Last week was a volatile period as stocks ended last week with a deep sell-off. The decline occurred soon after the FED Chair Jerome Powell’s press conference as he cautioned the recovery may be uneven. The cautious tone from the FED and the ongoing concerns about a second wave to the coronavirus pandemic triggered a rare technical chart pattern commonly referred to as a bearish island reversal pattern on 6/11/20.
A bearish island reversal is a short-term reversal pattern that is accompanied by two overlapping gaps namely a gap up followed by a gap down denoting exhaustion and breakaway gaps. As the name implies it is a warning to expect a price decline, at least from a near-term perspective. In general, the changing from an upward trending price trend (bullish) to a downward trend (bearish) tends to be more common than the latter. The signal is most reliable if it occurs after a strong trend. If the trend is weak, so is the signal. Some believe island reversal patterns are not too reliable or specially the pattern does not tell us anything about the next directional trend. Nonetheless, whether island reversal patterns are reliable or not may not matter as much as that these technical patterns are signaling an increased in market volatility over the near-term. Also note, toward the end of the week is the quarterly options expiration week and next week coincides with the end of the second quarter and the first half of the year.
On the charts, an island reversal is associated with a breakaway gap followed by an exhaustion gap to close out the formation. The gap up (exhaustion gap) represents a climatic move aligned in the direction of the existing trend. However, instead of following through with the gap up momentum, the trend peaks and begins to weaken resulting in a gap down (breakaway gap). This warns of the potential for a near-term reversal in the existing uptrend.
While many believe all gaps must be filled, the island reversal pattern is based on the idea that the gaps may not be filled, at least not from a near-to-medium term basis. Psychologically, it reflects an overconfidence on the part of buyers that subsequently allows sellers to gain control of the trend. This is a rare but potentially powerful pattern. If the gap up and gap down are filled, then the bearish island reversal begins to lose its significance. Some also believe a convincing move above the top of the bearish island reversal pattern is required to ensure the resumption of the primary uptrend.
Enclosed below are bearish island reversals in S&P 500 Index (SPX), Dow Jones Industrial Average (INDU), and NASDAQ NDX 100 Index (NDX). The gap ups and gap downs or the islands represent key initial resistances. The highs associated with the bearish island reversals offer secondary resistance. Filling the gap ups and gap downs are generally interpreted as positive technical developments. However, convincing surges above the top of the island reversal patterns can reaffirm the resumption of the primary uptrends.