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Island reversals are isolated data points separated by gaps. After an extended rally, the stock "gaps" higher, that is, it proceeds to open outside of the most recent trading range. After trading in the new higher range for several sessions, a second gap occurs, only this time the move is lower.
Such reversals frequently show up when trend is in a mature stage or in its final stages. An island reversal gets its name from the fact that the plotting of such data points, in a 'candlestick' pattern, shows the candlestick appearing to be all alone, as if on an island.
Formation of an island is an omen of reversal. They are rare in occurrence, but when one does happen, one can expect it to move the markets with a brutal force, in the opposite direction from which it came.
An island top formation indicates a reversal from a bullish to bearish trend, while an island bottom formation indicates a reversal from a bearish to bullish trend. After an uptrend, when a island reversal forms, this is what happens. Trading opens with a huge price gap, up on the first session. Thereafter, the price consolidates for the next couple of sessions. Thereafter, on the day following the consolidation, trading opens even lower than the level before the gap opened.
For instance, the Sensex had an all-time high of 21,206 on January 10. Thereafter, it plummeted by 27 per cent in just eight trading sessions. On January 22, it made an intermediate bottom of 15,332 and got back above 18,000. On February 4, it opened with an upward gap and closed the day at 18,660, with a gain of 418 points. This created a gap of 127 points between the previous day's high of 18,312 and the February 4 low of 18,439. On February 5, the Sensex added another three points to its rally but on February 6, fell sharply lower. As a result, a downward gap of 235 points was created between the February 5 low of 18,509 and the February 6 high of 18,274.
A cursory look at the given chart would tell you that on the daily candlesticks chart of the Sensex, an island cluster had been formed. Many considered this correction to 15,300 a routine one and hoped the Sensex would not only recapture its old high but also go beyond. We had extensively studied the pattern and also remembered the carnage it brought in our markets in the year 2000. The Sensex plummeted 31 per cent in a month after the appearance of the island reversal.
Applying the same logic, we derived the approximate target of 13,075 for the Sensex for the island reversal pattern formed on February 6 and sounded the alarm. This target was achieved on July 1, 2008, in a short span of four months.
The writer is director and head of research, Anagram Capital
