Island Reversals

December 4, 2012 (11:30 pm)

Island reversals are defined as compact trading activity within a range of prices, separated from the move preceding it and the move following it. This separation is caused by an exhaustion gap and the subsequent move in the opposite direction occurs as a result of a breakaway gap.

More simply, an island reversal is a chart formation where this is a gap on both sides of a topping or bottoming pattern. They frequently show up after a significant trend is in its final stages. A key sign of a valid island is an increase in volume at both gaps.

This formation is an extremely good indicator of a reversal and tends to be most reliable if it occurs after a strong trend. High volume should be expected in the island trading area.

Apple has seen a number of clear-cut island reversals in the past, as well as a couple messier patterns that could be considered island-like indicators. These are important formations indicating a strong change in sentiment, and we’ll be keeping a close eye on potential formations going forward.

October 2011: Heading into October earnings, Apple gapped up (exhaustion gap) and traded in the $420 area for a couple of days. It missed earnings and gapped down (breakaway gap), forming a very clear island top reversal. The shares proceeded to drop another $50 (12.5%) after the move.

December 2011: Apple gapped down (exhaustion gap) to the $380 area for a couple of days before gapping back up (breakaway gap), forming a clear island reversal. The shares proceeded to run in an almost straight line from $385 to $644.

March 2012: After Apple’s nearly-parabolic run in 1Q 2012, it formed an exhaustion gap at $580 before continuing its run to $644. On its way back down, it formed a breakaway gap at $618 and continued down to $550 (11% drop) and eventually $522 (15.5% drop). This instance is not a clear island reversal, but has similar characteristics.

July 2012: After Apple missed July earnings, it formed an exhaustion gap at $575. After three days of consolidation, the shares formed a breakway gap up to $582 and continued to rally to $705 (20% gain) over the next six weeks.

September 2012: An exhaustion gap was formed at $670 as Apple’s rally to $705 was nearing its end. After some consolidation near the top, the shares formed a breakaway gap at $680 and fell almost straight down to $505 (25% drop). This was a pretty clear island top reversal.

November 2012: On its way to find the eventual bottom at $505, Apple formed an exhaustion gap at $575. After capitulation at the lows, it formed a breakaway gap at $530 and continued its run back up. It has since hit $590, or an 11% gain from the breakaway gap.

Clearly this is an important formation to keep an eye on, as a number of Apple’s most significant trend-reversals were formed by islands. Some were formed within clear-cut islands and some were less clear, but these gaps will be important signals going forward.