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What is an island reversal?

An island reversal is short-term reversal pattern that forms with two overlapping gaps. Traders with positions taken between the two gaps are stuck with losing positions. A bullish island reversal forms with a gap down, short consolidation and gap up. A bearish island reversal forms with a gap up, short consolidation and gap down. Technically, the gaps should overlap to create an empty space above or below the island. The chart below shows the Coal ETF (KOL) with a bullish island reversal this week. Notice that the gap down and the gap up created a space above the island without any trades.

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The next chart shows Carnival Corp (CCL) with a bearish island reversal in early August. The stock gapped to 35, consolidated for six days and then gapped below 34.5. This created a small gap overlap without any trades. Buyers on the island were trapped with losses after this gap.

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While overlapping gaps create the “ideal” island reversal, a little flexibility is sometimes required for identification. Sometimes the gaps do not create a clear space above or below the consolidation, but there is clearly some sort of reversal at work. The chart below shows Apple Computer (AAPL) with a gap down, consolidation and gap up. Technically, the gaps do not overlap because the consolidation high exceeded the low of the gap down. Nevertheless, there is clearly a reversal in the works with this week’s gap.

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