The Island Reversal is a rare but important pattern that has shown up across many of India’s Major Indexes this month. As a result, I want to use this post as an educational opportunity to highlight what this pattern is, as well as explain how we’re interpreting it in today’s market.
Before we get into discussing the implications it’s important to understand the pattern itself, both mechanically and psychologically.
Edwards & Magee give us this definition which I think helps identify the mechanics of this pattern (remember this was written in the 1940s):
Island Reversal – A compact trading range, usually formed after a fast rally or reaction, which is separated from the previous move by an Exhaustion Gap, and from the move in the opposite direction which follows by a Breakaway Gap. The result is an Island of prices detached by a gap before and after…..The two gaps usually occur at approximately the same level. By itself, the pattern is not of major significance but it does frequently send prices back from a complete retracement of the Minor Move which preceded it”
Don’t worry if you can’t picture it in your head or quite grasp this concept (we’ll show you an example below), what’s more important is that you understand the underlying psychology that drives this pattern.
By definition, a reversal first needs a trend to be in place. In this example we’ll use an uptrend. As prices are moving higher, buyers are rewarded and shorts punished until there’s a gap higher that creates a buying climax as longs rush in and shorts throw in the towel. Following this move, prices consolidate for a period of time during which buyers and sellers continue to place their bets on the price range’s ultimate resolution, but neither supply nor demand are strong enough to resolve it. Finally, supply exceeds demand and prices gap lower, trapping all of the buyers that bought at higher levels. This generally creates a sharp move lower as longs rush for the exits and shorts start, or add to, their positions.
The intensity of the downside follow-through after this reversal occurs typically provides some insight into whether it marked a short-term top or is the beginning of something much more significant. The ability of buyers to reclaim control and close that gap quickly, however, would be a data point that reaffirms the uptrend’s strength.
And so the point of explaining all this is because we’re seeing this pattern play out across all of the major indexes we cover, with the exception of the Nifty 50 which we’ve been highlighting the relative strength in all year.
In the case of the Nifty 500 chart below, this reversal also happened to coincide with a failed breakout above the January highs, but there was no bearish momentum divergence and so far RSI has stayed out of oversold conditions as prices correct to the downside.
So what we want to be watching for in the Nifty 500 and other indexes is if prices can quickly close the gap and move to new highs, or if sellers hold that gap and continue to push prices lower and momentum into oversold territory. Given the sector rotation occurring under the surface and the other bullish data points we’ve discussed on the blog over the last month, I’d say the former is the higher probability outcome, but we’ll continue to watch and reevaluate our thesis as more data comes in.
Thanks for reading and please let us know if you have any questions.
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