It’s funny, some friends of mine a few weeks ago were asking me about Island Reversals. Apparently they were arguing about whether a breakout in some stock was sparked by an island reversal or not. I came to the conclusion that they were both wrong, but I appreciated their interest in this rare pattern. The point I tried to make to them was that it wasn’t so much about what it’s called, but more about its implications. And they had the implications right, which is all that mattered.
I don’t see too many of these things, but this week we got a classic example of the ever so elusive “Island Reversal”.
From Edwards & Magee (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”
I’ve always found it easier to visualize things. In this chart of the Nasdaq100 Index, you can see a gap higher above the January and February highs. This is the “Exhaustion Gap”, which is the last and final thrust of a move. After a few days up there, prices gapped again, but down this time. We call these “Breakaway Gaps” because they come at the beginning of a move. The combination of these things is what we call an “Island Reversal”, because it looks like an island is left alone up there.
For me, it’s not so much the Island Reversal itself, but where that Island Reversal shows up that matters most. In this case, we’re talking about new all-time highs above resistance the past couple of months in the Nasdaq 100 Index. That’s kind of a big deal, and it failed:
What this Island Reversal left behind was a big mess. Taking a step back, this failed breakout (the island reversal), confirmed a bearish momentum divergence. These aren’t things we see in strong uptrends.
So what does this mean? Well, it means that 7000-7100 area is very important. The behavior of the market suggests this is a major point of interest for buyers and sellers, which is what we care most about. I have a funny feeling we will be discussing this 7000-7100 level for a long time. This area should be more overhead supply in the future, and if/when we do break out above it, I would expect it to become support at some point down the road. I wouldn’t be surprised if we’re discussing this particular level for years to come. I think it’s that important.
Let’s talk about the implications. First, we know this is overhead supply for sure. So we don’t want to be aggressively long from any sort of intermediate-term perspective, unless we’re above that. The risk here is to the downside, not the upside. We will get rallies, possibly even back towards 7100, but I think they will fail for now.
My big question is not whether or not this will be a problem, but for how long. This 6-day reversal is not something like a multi-month long Island Reversal that could cause a multi-quarter or multi-year sell-off. This is just a little guy. But the point is that it is revealing to us where that supply and demand equilibrium really lies. We can’t ignore that.
The sooner we can get through that level, the stronger the market we’re in from a short-term to intermediate-term perspective. In the meantime, I would expect further chop fest at best in the Nasdaq.