By: Steve Smith
This morning’s sharply higher opening had many investors heaving a momentary sigh of relief. However, the damage done by the recent sell-off might prove longer lasting and lead to further downside. Today’s investing advice will explain this potential problem in more detail.
Today, we’ll hear from market technician J.C. Paret, who recently posted about the problems that this sell-off poses on his All Star Charts blog.
Here’s what he has to say:
It’s funny, some friends of mine a few weeks ago were asking me about Island Reversals. Apparently, they were arguing about whether a breakout in some stock was sparked by an island reversal or not. I came to the conclusion that they were both wrong, but I appreciated their interest in this rare pattern.
The point I tried to make to them was that it wasn’t so much about what it’s called, but more about its implications. And they had the implications right, which is all that mattered.
I don’t see too many of these things, but this week we got a classic example of the ever so elusive Island Reversal.
Island Reversal – A compact trading range, usually formed after a fast rally or reaction, which is separated from the previous move by an Exhaustion Gap, and from the move in the opposite direction which follows by a Breakaway Gap. The result is an Island of prices detached by a gap before and after…The two gaps usually occur at approximately the same level. By itself, the pattern is not of major significance but it does frequently send prices back from a complete re-tracement of the Minor Move which preceded it”
I’ve always found it easier to visualize things. In this chart of the Nasdaq 100 Index, you can see a gap higher above the January and February highs. This is the “Exhaustion Gap”, which is the last and final thrust of a move. After a few days up there, prices gapped again, but down this time. We call these “Breakaway Gaps,” because they come at the beginning of a move. The combination of these things is what we call an Island Reversal, because it looks like an island is left alone up there.