Island Reversal Explained: A Step-by-Step Guide Identifying Island Reversals on Charts

In this article, we will discuss

Most trend reversal patterns tend to occur within one or two trading sessions at most. This leaves little room for traders to assess and anticipate a reversal and take advantage of it. The most notable exception to this is the island reversal pattern, which occurs across several trading sessions or days.

By combining candlestick chart tracking with in-depth technical analysis, you can identify and use this reversal indicator to your advantage. Let us examine what this pattern is, why it occurs and how you can trade it.

What is the Island Reversal Pattern?

The island reversal pattern is a rare trend shift indicator featuring a period of trading activity that is distinct and separated from the preceding and succeeding trends. This period of trading activity resembles an island, giving the pattern its name. The island is separated from the previous and following trading sessions by noticeable trading gaps or jumps.

During the trading sessions that make up the island, the price tends to consolidate and move sideways. At the end of this consolidation phase, the price generally breaks out and moves in the direction opposite to the trend that preceded the island.

Types of Island Patterns

Depending on where they occur and the direction in which the price reverses, island patterns can be bullish (bottom) or bearish (top). Let us take a closer look at each of these types of island reversals.

  • Island Top

As its name indicates, the island top pattern occurs at the end of a prevailing uptrend. Hence, it occurs at the top of the chart. There is a gap up at the start of the island and a gap down at the end, after which the price trends downward. Since this signals a shift from an upward to a downward trend, the island top is also known as a bearish island reversal.

  • Island Bottom

This type of island pattern occurs at the bottom of a price chart — generally at the end of an ongoing downward trend. The first gap in this pattern is a gap down, while the second is a gap up. After the island formation comes to an end, the price reverses and moves upward instead. So, the island bottom is also called a bullish island reversal pattern.

Key Characteristics of the Island Pattern

An island pattern is marked by a set of distinct characteristics that make it easy to spot and hard to miss. These key features include the following:

  • A Strong Initial Trend

The island is generally preceded by a strong upward or downward trend. It should have also been a prolonged price movement and not just a short-term trend.

  • A Noticeable Initial Price Gap

The first sign of the formation of the island is a noticeable initial price gap. The gap can be upward (in the case of an island top) or downward (in the case of an island bottom).

  • A Defined Consolidation Period

After the first gap is formed, the price consolidates within a tight range over several trading days. This marks the island, which is separated from the rest of the chart by price gaps.

  • A Strong Final Price Gap

The final price gap occurs at the end of the island, in the direction opposite to the first price gap. That said, both price gaps tend to occur at the same or similar price levels.

  • Trading Volume

The trading volume is generally high during the formation of the initial and final price gaps. Additionally, it may also be high during the consolidation phase itself.

  • A Trend Reversal

The last but perhaps the most defining feature of the island pattern is the trend reversal itself. When the price breaks out of the final gap, it moves in the opposite direction to the original/initial trend.

Trading the Island Reversal Pattern

Before you enter or exit a trade based on the formation of the island pattern, you need to first identify the pattern correctly and confirm its presence. A short island spanning just 1-2 trading sessions is not highly reliable. The longer the consolidation phase, the stronger the reversal signal is likely to be.

Once you have established that an island reversal is indeed on the cards, you can develop a trading strategy for the potential trend shift. Here is how you can set the entry point, stop-loss and take-profit limit for your trade.

  • Trade Entry

Many traders tend to react hastily and enter the market before the island has fully formed and the second price gap has occurred. This is risky because you may end up trading based on a false signal. The smart thing to do is to wait for the island pattern to form fully and the price to break out of the second gap. Then, you can enter the market in the direction of the breakout.

This means you will take a long position (or buy) at the end of an island bottom and a short position (or sell) at the end of an island top.

  • Stop-Loss

A stop-loss is an essential risk management tool for traders. You need it not just because the island pattern could offer a false signal but also because even if a reversal does occur, it may not succeed in sustaining long enough.

One way to place a stop-loss if you are trading this reversal pattern is to use the lowest or the highest price points within the island itself. For an island top, the highest point becomes the stop-loss (and vice versa).

The downside of this strategy is that the stop-loss limit may be too tight, leading to unnecessarily swift exits. A more effective alternative would be to identify the nearest resistance or support level and use that as the stop-loss level for your trade.

  • Take-Profit or Trade Exit

Here too, the support and resistance levels can be helpful. If you are trading an island top, you could identify a strong support level below the pattern and use that as the take-profit level. Similarly, if you are trading an island bottom, the nearest noticeable resistance level can act as the exit point for the long position.

Another way to set the take-profit level is to use your preferred risk-reward ratio (which may be 1:2 or 1:3) and decide the exit price based on this ratio.

Conclusion

This concludes our discussion on the island pattern. Although it is a rare pattern, it can be quite useful when it does occur, primarily because the signals it offers are generally strong and reliable. That said, you must always rely on other technical indicators to confirm the signals before implementing a trading strategy based on the island pattern. This will help you avoid any potential false signals and ensure that you can manage risks and rewards smartly.

Disclaimer: INVESTMENT IN SECURITIES MARKET ARE SUBJECT TO MARKET RISKS, READ ALL THE RELATED DOCUMENTS CAREFULLY BEFORE INVESTING.
The asset classes and securities quoted in the film are exemplary and are not recommendatory.
SAMCO Securities Limited (Formerly known as Samruddhi Stock Brokers Limited): BSE: 935 | NSE: 12135 | MSEI- 31600 | SEBI Reg. No.: INZ000002535 | AMFI Reg. No. 120121 | Depository Participant: CDSL: IN-DP-CDSL-443-2008
CIN No.: U67120MH2004PLC146183 | SAMCO Commodities Limited (Formerly known as Samruddhi Tradecom India Limited) | MCX- 55190 | SEBI Reg. No.: INZ000013932
Registered Address: Samco Securities Limited, 1004 - A, 10th Floor, Naman Midtown - A Wing, Senapati Bapat Marg, Prabhadevi, Mumbai - 400 013, Maharashtra, India. For any complaints Email - grievances@samco.in
Research Analysts -SEBI Reg.No.-INHO0O0005847

Download App to know your Andekha Sach

Get the link to download the app.

QR
Google Play Store App Store
Samco Fast Trading App

Leave A Comment?