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.
The first example shows Chipotle Mexican Grill (CMG) with bearish island reversal. Note the gap up in early January, the consolidation into early February and the gap down in early February. Prices gapped above 696, held above 696 and then gapped below 696 to create the island. Traders establishing long positions on the island are now trapped with losses.
The second example shows Raytheon (RTN) with a bullish island reversal. There is a gap below 104, a three day stall and then a gap above 104. There were no trades at 104 because of the gaps. Thus, traders establishing short positions on the island are now trapped with losses.