Last Updated on 17 November, 2020 by Samuelsson
There are a lot of chart patterns out there, and with so many, some won’t get the attention they might deserve. One such chart pattern is the island reversal.
An island reversal is a chart pattern that consists of a group of bars that are separated by gaps on either side. As its name suggests, the island reversal is a reversal pattern which shows that the current trend soon is to be replaced by a trend in the opposite direction.
In this guide to the island reversal pattern, we’re going to take a closer look at the pattern and how it’s used in trading. You’ll also learn a couple of tips to help increase the profitability of the pattern.
How to Identify an Island Reversal
Island reversal patterns come in in two versions:
- Bullish Island Reversal
- Bearish Island Reversal
As is quite apparent given their names, the bullish island reversal is a bullish pattern and occurs in a bearish trend.
A bearish island reversal, on the other hand, is a bearish pattern occurring in a bullish trend.
Let’ have a closer look at both!
Definition of the Bullish Island Reversal
Here are the four main characteristics of the pattern:
- The first thing to look for is that the market is in a downtrend. We simply want there to be a bearish trend that can be turned around.
- The second thing to look for is a negative gap, which marks the start of the pattern.
- Then, once the gap has formed, the market should either continue down a bit or start consolidating. It’s important that the gap zone remains intact. The price may peak through temporarily but should recede quickly.
- After the market has been trading below the gap for some time and formed what sometimes looks like a “clutter” of price action, it produces a positive gap. Preferably it should occur at or very close to the price level where the first gap formed.
In the image below you see an example of a bullish Island reversal pattern. Now you might also realize why the pattern is called an island reversal. The price action between the two gaps simply forms what looks like an island.
The Psychology Behind the Island Reversal
Price patterns tell us something about the market and where it’s headed, and it’s always interesting to look at them from a psychological perspective. And while it might be hard to get an exact answer as to what the exact reasons behind a move were, it certainly can be enlightening to look at the market from a new perspective.
So, let’s have a look at the psychology behind the bullish version of the pattern!
As the market is in a bearish trend, most market participants are bearish on the market. In other words market sentiment is mostly negative, and the negative gap that marks the start of the coming island reversal is another strong indicator of that. In that sense, we’re told that there still remains a lot of bearish sentiment and that the market might be headed even lower.
This holds true, at least to some extent, as the market continues down a bit. However, soon bulls start to sense that the market is becoming worth buying and add to the increase in buying pressure. The market steadily climbs up to the zone where the previous negative gap occurred. This zone now has become a resistance zone, which usually is a level in price that’s hard to break through. However, this seems not to disturb the bulls the slightest, and instead of retreating, they manage to perform a positive gap that adds to the new, positive sentiment.
So, in short, the island reversal pattern is an example of how the market forces shifted, manifesting itself in the shift of the direction of the gaps.
Common Ways to Improve the Island Reversal
There are a couple of ways that you can go about to increase the profitability of the signal. So let’s have a look at some of the most common methods:
By watching whether the volume of the market is increasing or decreasing throughout the island, we may gain some clues about whether the pattern is worth taking or not.
Many traders will regard increasing volume as a sign that the market is preparing for the coming trend reversal. Thus, they take an island reversal forming under increasing volume more seriously than one where volume is falling.
2. The Size of the Gaps
Another aspect of the pattern some traders pay attention to is the size of the gaps. The most common opinion here is that the last gap should be bigger than the first gap since bigger gaps generally are more significant.
3. The Length of the island
While there usually is no limit as to how long the island may take to form, there is a chance that too long islands remain undetected by market participants. That’s why the general advice is to not look at patterns with an island longer than roughly three months
The island reversal is a price pattern that can be both bullish and bearish and shows that the current trend is coming to an end. In short, it could be said to consist of a gap in the direction of the trend, followed by an island-like price formation, which ends with the last gap which forms in the direction opposite of the preceding trend.