Spotting reversal candlestick patterns can bring considerable profits. One of the prominent patterns is the Island Reversal formation, which often marks a potential trend reversal and appears clearly on candlestick charts. It gives traders a chance to enter the market with lower risk and benefit from a strong price move.
The Island Reversal pattern offers a means to determine entry points, as well as stop-loss and take-profit levels. This article explores the nature of the Island Reversal pattern and shows how to use it in trading.
The article covers the following subjects:
Major Takeaways
- An Island Reversal pattern is a chart formation in which several candlesticks are isolated from the main price movement by two gaps, an initial gap and a final gap, which together create a distinct island pattern on the price chart.
- To recognize an Island Reversal, look for a bullish gap or bearish gap, followed by a brief price consolidation, and then another price gap in the opposite direction. This movement creates a cluster of candlesticks that appears isolated from the price action.
- Island Reversal chart patterns can be either bullish or bearish, depending on the direction of the gaps and the preceding trend.
- To confirm the reversal, technical analysts often use tools such as MACD, RSI, moving averages, MFI, VWAP, and OBV.
- Set your stop-loss order slightly below or above the Island Reversal, and your take-profit order at a distance virtually equal to the height of the pattern.
- Although the Island Reversal pattern can be found on different time frames, it is more reliable on daily and weekly charts, where market movements and sharp changes in direction are easier to detect.
- This pattern can appear in various markets, including the stock market, Forex, and cryptocurrencies, and is especially common in regions with frequent stock gaps, such as the Indian stock market. However, its performance may vary depending on the specific asset and the prevailing market conditions. Notably, it is most commonly observed in the stock market.
What Is the Island Reversal Pattern?
The Island Reversal pattern signals a potential trend reversal and often reflects a dramatic shift in market sentiment. The “island” is separated from the rest of the chart by two price gaps, often referred to as an initial gap and an exhaustion gap, which together form the isolated structure of the island gap. The first gap appears when the previous trend ends. The second gap indicates a potential new trend.
The “island” itself can be small, consisting of either one or several candlesticks that form a sideways channel. This pattern often appears after a prolonged increase or decrease and indicates that the market may change direction soon.
The pattern shows that the original trend is gradually fading, and traders are slowly opening positions in the opposite direction, expecting a reversal. However, the Island Reversal pattern is just one of the tools of chart analysis and should be confirmed by other technical analysis indicators, especially in markets where low volume may produce false islands or false signals. Therefore, always consider the overall market situation.
How to Identify Island Reversal Patterns
To recognize an Island Reversal on the chart, you need to stay attentive and watch for a few key factors.
- Identify the current trend. Determine whether the price is moving up or down and assess whether the prevailing trend aligns with the conditions required for an Island Reversal.
- Spot the price gap. Look for a sharp price jump, separating a group of candlesticks. This sharp movement is usually where price action creates the beginning of the island. The gap should be clearly visible on the chart.
- Find the “island”. After a sharp move, the price often pauses and moves in a tight trading range, forming the “island”.
- Confirm the reversal gap. Once the Island Reversal forms, the price reverses, creating an Island Reversal top or Island Reversal bottom, depending on the setup.
- Monitor trading volume. High volume often validates the reversal, while low or inconsistent activity may signal a false breakdown.
- Determine support and resistance levels. After the Island Reversal emerges, define the levels at which the price may slow down. These levels can be used when setting stop-loss and take-profit orders.
- Confirm the pattern. Use technical indicators such as the RSI, MACD, or moving averages, as well as other candlestick patterns. If different indicators confirm the Island Reversal, you can open a trade.
Bullish Island Reversal Pattern
A Bullish Island Reversal signals an imminent upward reversal.
Initially, there is a steady bearish trend, followed by a gap down, which often reflects weakness in the existing trend before the pattern begins to form. This gap separates a small section of the chart from the main price action.
In the isolated price area, quotes consolidate within a narrow range. The sideways movement reflects indecision, showing a struggle between bulls and bears.
Next, a breakaway gap appears, and the asset starts to grow. This gap separates the Island top from the next price increase, confirming that buyers have gained the upper hand and the price will keep rising. Therefore, one may consider long positions.
Bearish Island Reversal Pattern
A Bearish Island Reversal indicates a downward reversal after a sustained upward trend.
At first, prices rise within a bullish trend. Afterward, an upward gap forms, isolating a small part of the chart from the major trend, creating an “island”.
This pattern usually forms quickly. The “island” may consist of just a single candlestick or a small cluster of candles.
The most critical moment is when a downward gap forms. This gap isolates the Island bottom from the subsequent bearish movement, confirming that the trend has switched to bearish. An increase in trading volume can serve as additional pattern confirmation. If the volume rises, you can open a short position.
Island Reversal Pattern Trading Strategy
Trading with the Island Reversal pattern requires careful analysis and confirmation with additional tools. Many traders also consider an asset’s past performance and similar setups to better identify opportunities. Although this pattern allows traders to open profitable positions, it is crucial to follow risk management rules. Let’s review an example of a trading strategy utilizing a Bullish Island Reversal on a 4-hour chart of Bank of America stocks.
How to Confirm Island Reversals
To confirm the Island formation, pay attention to several critical aspects.
Increased volume during the formation of the second gap strengthens the signal. When volume is low, however, the signal may turn out to be false. In the example below, after the second upward gap appears, the MFI indicates an inflow of liquidity, confirming a bullish reversal.
Technical indicators are essential. For example, one may use the RSI or MACD to understand how overbought or oversold the market is. On the chart below, the RSI rebounded from the lower boundary and started to rise, while the MACD crossed above the signal line, indicating growing bullish momentum.
Additionally, analyze the price behaviour after the Island Reversal completes and seek confirmation from momentum indicators. Once the second gap occurs, the trend should reverse.
If the stock price fails to break through the resistance or support level or returns to the pattern’s boundaries, the signal is likely weak, and the trading plan should be revised. In the setup below, after the upward gap, confirming Inverted Hammer candlestick patterns appear, and the price begins to advance.
Finally, you should always consider the market situation. Use higher time frames to see the overall trend and make sure the Island Reversal pattern is reliable.
Entry Points
For risk-averse traders, it is safer to wait until the price breaks above key resistance (in a bullish setup) or below support (in a bearish one). Once the price holds beyond these levels, you can enter the market. If you are willing to take on more risk, you can open a position immediately after the second gap forms. In this case, the price is expected to move quickly in the opposite direction of the prior trend. However, you must monitor the market closely and be ready to exit fast if the breakout proves to be false.
Another signal may appear when the price breaks through nearby support or resistance levels after an Island Reversal has formed. In the example below, the optimal entry point would be to open a long trade once the Island Reversal formation is complete and confirmed by technical indicators as well as other candlestick patterns.
Stop Loss Placement
A stop-loss order is usually set just below the pattern if you expect the price to go up, and just above the Island Reversal if you expect it to go down. This way, you will limit your potential losses if the signal turns out to be false.
The second option involves setting a stop-loss order close to the entry point while calculating the risk-to-reward ratio. For instance, for every dollar of risk, you aim to earn two or three dollars, achieving a ratio of 1:2 or 1:3. Although this strategy can boost potential profits, it also raises the risk of the stop-loss being triggered prematurely due to minor price fluctuations.
In the example below, the stop-loss order is placed slightly below the second gap and the Inverted Hammer candlestick pattern.
Importantly, if the market is highly volatile, it is better to place your stop-loss order further away so it does not get triggered by accident. The key is to find a balanced middle ground.
Conclusion
The Island Reversal pattern is a valuable candlestick pattern for traders, helping spot potential trend reversals in advance. However, this pattern does not guarantee a successful trade, so it is better to double-check it with technical indicators such as MACD, RSI, MFI, and others. To trade successfully with the Island reversal pattern, you need to be diligent, patient, and mindful of the risks.
When you trade Island Reversal patterns, it is crucial to take overall market conditions into account and choose the appropriate stop-loss size. Remember that online trading always involves risk, so make sure to learn the basics before investing real money. You can test the Island Reversal pattern for free on a LiteFinance demo account and then apply it in live trading.
Get access to a demo account on an easy-to-use Forex platform without registration
Island Reversal Pattern FAQs
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance broker. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2014/65/EU.
According to copyright law, this article is considered intellectual property, which includes a prohibition on copying and distributing it without consent.