The Island Reversal Gap Chart Pattern
The Island Reversal Gap Chart Pattern is a commonly occurring chart pattern in the stock markets. In fact the name comes from the stock markets as gaps were quite a common phenomenon in the equity markets. However, the island reversal gaps in the forex markets are not that frequent. While gaps in the forex markets, especially on a Monday open are now common, finding an island reversal gap is quite rare. Therefore, traders who are interested to trade this pattern are better to act when the pattern emerges rather than simply wait for the pattern and stay on the sidelines.
Among the many different types of patterns, the island reversal gap patterns are unique as they have higher odds of being successful. The island gap pattern can be typically applied to any time frame, although it is best to limit this pattern to the 15-minute chart and higher time frames in the forex markets. The island gap reversal pattern, as the name suggests is a reversal pattern. When you see this pattern emerging after a strong uptrend or a strong downtrend, you can expect the markets to reverse. Stock market traders also make use of volume as an additional confirmation tool.
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In the very short term, the island gap reversal pattern can be a good way to speculate the markets. It is a pattern and not a strategy therefore; traders should combine the island gap pattern with other confirmation indicators or trading strategies.
How is the Island Reversal Gap Chart Pattern formed?
The island reversal gap chart pattern is formed when price is declining or falling but you see two gaps; the first gap occurs in the direction of the trend, followed by either a single or multiple sessions trading within a range and then a gap in the opposite direction occurs. Depending on how and where this forms (especially near support or resistance levels) the island gap reversal pattern increases the probability of a trade.
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The Island Reversal Top Pattern
The island reversal top pattern is identified by an up gap in an uptrend followed by a down gap during the third session. However, traders should give this a lot of flexibility as sometimes you can expect the following down gap to occur after three or even four session.
What matters is that you find the two overlapping gaps to be formed in the opposite direction. In Figure 1, we have an island reversal top pattern that was formed after price rallied to a certain extent. Following this rally, we can see that price first gapped higher following which after the next session, price then gapped down lower.
Here, you can see that after the down gap occurred, price posted a steady decline and fell sharply. As the above chart illustrates, the island gap pattern is a very powerful pattern which can signal a sharp move.
The Island Reversal Bottom Pattern
The island reversal bottom pattern emerges at the bottom of a downtrend. Here, you can see that price gaps lower and after the next session, an up gap is formed. Following this bottom reversal pattern, price then posts a sharp rally. In Figure 2, you can see that island reversal bottom pattern. Here, price first declined followed by a down gap. Following the next session, price then gapped higher and followed through with a rally.
In the above example you can see how price did not even make a pull back. Thus traders who were trapped in the opposite direction would have seen some severe losses.
Trading rules and stop loss
As with any pattern based trading, it is not advisable to trade the patterns in isolation. This is due to the fact that at times the markets can trap traders before reversing direction. Therefore, traders must look to the market context and take help of other indicators if need be in order to have at least two confirmations before trading. Assuming that you are trading with the island gap pattern, simply place your trades after a bearish close in an island top pattern following the down gap or wait for a bullish close after the up gap in a downtrend.
For stops, you can place the stops at the recent pivot high (in an uptrend and for a island reversal top pattern) or at the recent pivot low (in a downtrend and for an island reversal down pattern). The targets can be based either on risk reward ratio set up or you can use other trading indicators or strategies to book your profits.
The Island Reversal Patterns aren’t that common to the Forex markets, but they do occur from time to time. When the pattern occurs, you can be sure that the markets will be positioned very strongly. Traders should also pay attention to the risk as a fake reversal could potentially keep you on the losing side very quickly.