The World’s Most Important Island
Ok, I have to admit the title is a bit sensationalized. The world, in the case of this blog post includes all of the world except the US and Canada. With that in mind, a very interesting island reversal pattern has developed in EFA, the index ETF that attempts to track the worlds developed stock markets (sans US and Canada).
Island Reversals (From Stockcharts.com)
An island reversal is a reversal pattern that forms with two gaps and price action in between the two gaps. These gaps tell us that the island reversal marks a sudden, and sharp, shift in direction. Even though they are relatively uncommon, island reversals are potent patterns that warrant our attention.
The alignment of the gaps holds the key. First, note that a bullish island reversal forms with a gap down and then a gap up. A bearish island reversal forms with a gap up and then a gap down. These gaps overlap to create an island of price action, hence the term “island reversal”. The island is above the gaps on a bullish island reversal, and below the gaps on a bearish island reversal.
Taking a look at EFA’s chart we can see yesterday’s gap down formed the final candle to confirm the pattern. If you look left, in spite of their rare occurrences, I circled where EFA formed an island top reversal in December which lead to a 10% decline. Because EFA is below a falling 200 day moving average, is making lower highs and lower lows, this pattern has major significance and a warning to investors of the potential for another leg down in stocks. If and only if price reverses course higher soon, fills the gap and closes above Friday’s high does it negate this bearish pattern. Forewarned is forearmed.
For traders, this is a nice-looking short selling risk-reward setup. Selling short Tuesday’s close and using a stop just above last Friday’s high as your stop, offers a trading opportunity providing a potential $4 gain for every $1 risked. Downside target is back at December’s low.