Traders often look for technical analysis patterns for clues to determine the next directional trend. It has become a widely followed trading discipline utilized by many momentum and swing traders.
While there are many trading patterns, they all follow the same logic. Patterns falling under the reversal category alert traders to the potential for a change in the direction of the trend. One of the most significant reversal patterns is the island reversal.
An island reversal can be bullish or bearish. It typically forms after a quick rally or decline and is separated from the previous move by either a gap-up (breakaway) or gap-down (exhaustion gap). The isolated price separated by the two gap patterns forms an island reversal pattern.
The reversal pattern rarely occurs. But when it does, it is a significant development, signaling an impending price reversal. An island reversal can appear within a single trading session or for several days or weeks. Volume tends to expand near the island formation.
The bullish island reversal pattern typically appears in a downtrend. After the initial gap-down, the stock either consolidates or continues to fall. A second gap-up appears near the price level of the first gap, confirming the bullish reversal pattern.
The buying and selling rules for a bullish island reversal pattern -
(1) Wait for the bullish reversal pattern to develop. (2) Establish a buy-stop order just above the gap-up area. (3) Place a sell-stop loss order directly below the gap area. (4) Take profits are subjective and based on the time frame and risk tolerance levels. The island reversal pattern tends to result in a follow-through rally to an earlier reaction or swing high.
The bullish island reversal is infrequent but is a reliable indicator. When the pattern develops, it increases the chance for an impending trend reversal. Like other technical patterns, it should be deployed in conjunction with other technical indicators and disciplines to confirm the direction of the trend.
An SPX gap-down in 5/4/23 (4,02.61-4,088.86) followed by a gap-up in 5/5/23 (4,082.61-4,084.73) confirms a bullish island reversal pattern in 5/4/23. Interestingly, the reversal occurred the day after the May 2-3 FOMC meeting in which the Fed increased rates another quarter point, signaling a potential pause.
Despite an ongoing regional banking crisis and an impending debt ceiling debacle as early as Jun 2023, traders expect the Fed to end the tightening process soon. The recent island reversal pattern and a potential cup and handle pattern indicate traders are not expecting a recession in the second half of the year.
Although several key technical indicators, including the advance-decline line, SPX/WLSH relative strength, MACD price momentum, RSI overbought/oversold, and percentage of SPX stocks trading above their 200-day ma indicators, show mixed readings, the SPX bullish island reversal on 5/4/23 hints at a trend reversal favoring higher SPX prices. Initial trading resistance is 4,154.28-4,169.48 (4/18 and 5/10/23 highs) and above this 4,186.92 (5/1/23 high). A breakout suggests +138.64 points or 4,324.5 or a retest of the 8/16/22 reaction high (4,325.28) near term.
Another cup and handle pattern has developed. This bullish pattern has not succeeded over the past year because the primary trend has been a downtrend and, recently, a sideways trading range. Nonetheless, a convincing move above 4,186.92-4,195.44 (Feb/May 2023 highs) suggests +386.58 points or an SPX target of 4,582 intermediate-term.
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