Island Reversal: Definition, 5 Key Characteristics, and Example

What Is an Island Reversal?

An island reversal is a price pattern that, on a daily chart, shows a grouping of days separated on either side by gaps in the price action. Stock analysts read this pattern as an indication that the stock's price may reverse the trend it is currently exhibiting, whether from upward to downward or from downward to upward.

An island reversal be displayed on a bar chart or a candlestick chart.

Understanding the Island Reversal Pattern

Island reversals are a peculiar identifier because they are defined by price gaps on either side of a grouping of trading periods (usually days). While many analysts and traders hold the belief that gaps will eventually be filled (meaning that prices will retrace over any gap that previously occurs), the island reversal is based on the idea that the two gaps in the formation will often not be filled—at least not for a while.

The island reversal can be a top or a bottom formation, though tops are far more frequent between the two. That is, it more often indicates that the stock's price is reaching its top and is poised for a reversal.

The island reversal formation has five standout characteristics:

1. A lengthy trend leading into the pattern.
2. An initial price gap.
3. A cluster of price periods that tend to trade within a definable range.
4. A pattern of increased volume near the gaps and during the island compared to the preceding trend.
5. A final gap which establishes the island of prices isolated from the preceding trend.

This depiction shows an island reversal top, or bullish island reversal, and forecasts an end of the preceding upward price trend. An island reversal bottom would forecast the end of preceding downward price trend and the start of an upward trend in price.

A Bearish Island Reversal Example

A bearish island reversal, the more common type of example, will be charted over a series of days or weeks and is preceded by a significant upward move. In this example, the stock price makes a run to its highs, makes an island reversal, then returns to its highs only to make another island reversal.

In this unusual example where the price pattern actually displays two island reversals comprising a double top price pattern, the island reversals both show similar characteristics, including a rise in volume during the isolated section of trading days.

Inferences and Supporting Indicators

Island reversals may have a cluster of prices that span varying time frames of days, weeks, or even months. Thus it is essential to watch for the gaps that open and close this pattern.

Gap patterns occur when a significant difference in price is shown from one day to the next. Gaps up will be formed from two white candlesticks with the second showing an opening price higher than the previous day’s closing price. Gaps down occur from two red candlesticks with the second showing an opening price lower than the previous day’s closing price.

Island reversals, like all reversal patterns, will typically be supported by a later breakaway gap to initiate the island grouping, and then by an exhaustion gap to close out the formation.

The appearance of the exhaustion gap is usually the first sign of a new trend which will then include several runaway gaps in the new direction, followed by an exhaustion gap.

It should be noted that several authors who have researched this price pattern claim their research finds the pattern to occur infrequently and produce poor performance results.

The Bottom Line

Unlike fundamental stock analysts, technical stock analysts do not examine a company's books to determine if its stock is undervalued or overvalued. Technical analysts chart the stock's movements in the market to see if it is more likely to go up or down in price.

The island reversal pattern is one tool that technical analysts use to anticipate a change in a stock's price direction.