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Island Reversals and Gap Downs

What is the reason for today’s 5%-7% one-day market sell-off?


Some of the explanations include the risk of a second wave of the coronavirus pandemic as the US infections passed the two million mark and over 112,000 Americans have died from the pandemic. The seven-day average of new cases over the past two weeks has been rising in more than 20 US states. Another is the gloomy economic outlook by the FED in yesterday’s FOMC meeting. FED Chairman Powell raised the question of the quality and the pace of the recovery. Others claim the market has become increasingly speculative as the NASDAQ Composite Index and NDX 100 Index traded to all-time highs. Yet many believe Main Street has completely disconnected from Wall Street and a correction must realign the two markets.


By the end of the day S&P 500 Index fell 5.89%, Dow Jones Industrial Average plummeted 6.90% into the close, and the leadership NASDAQ Composite Index, which recorded new all-times highs declined the other day declined 5.27%. The losses steepen into the final hour of selling on very heavy volume. This led to one of the worst trading days since the height of the coronavirus pandemic in March 2020.


On a technical perspective, there were many bearish daily island reversal patterns (i.e., SPX, INDU, NDX, NYA, MID, SML, etc.) and a few daily gap downs (i.e., COMPQ, BTK, FDN, etc.).


So, what does this mean? A daily bearish island reversal occurs when a space occurs on the charts. A gap up is soon followed by a gap down creating a separation or the island. This technical pattern shows up after a strong bull trend. The gap down is often attributed to major news related driven events. Since this is a daily reversal pattern many traders view this as the start of a near-to-medium term correction. The typical duration is several days to a couple of weeks or more.


When the bearish island reversal pattern occurs when the prevailing trend of the market in question is in a dominant and rising uptrend, then the correction can lead to a retest of key initial technical supports such as pivotal moving averages (50-day and 200-day ma), prior technical breakouts, gap ups, or the important 38.2% retracement from the March to June 2020 rally. However, if the duration extends further to many weeks and key initial supports are broken convincingly then this can lead to the start of a deeper correction (10-20%).


Attached below are charts of the S&P 500 Index (SPX), Dow Jones Industrial Average (INDU), and NASDAQ Composite Index (COMPQ) along with updated technical levels.



Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

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