An island reversal sell signal?

In response to my last post (see Watching the USD for clues to equity market direction), an alert reader pointed that the SPX had formed a bearish island reversal.


Wikipedia explained the island reversal formation this way:

In stock trading and technical analysis, an island reversal is a candlestick pattern with compact trading activity within a range of prices, separated from the move preceding it. This separation is said to be caused by an exhaustion gap and the subsequent move in the opposite direction occurs as a result of a breakaway gap.

I had grown up with trading aphorisms and folklore like this, so I decided to test out whether the island reversal formation had any trading information. The results were surprising, and it was another lesson in how asymmetric signals were at tops and bottoms (see The ways your trading model could be leading you astray).

Asymmetry strikes again

My study used the daily open, high, low and close data of the SPX going back to January 1, 1990. I looked for instances of island reversals and calculated the returns of each episode. There were, on average, 1.5 reversals per year. As the table below shows, the results were surprising.


Bullish reversals, where the island reversed upwards, did not perform very well. The index saw a one day bounce and went on to underperform going out about a week. Bearish reversals performed a lot better than expected. Absolute returns were positive whatever time horizon you chose, though the index underperformed on a 2-3 day time horizon.

This gave me another lesson in the asymmetry of trading models. In the current instance, we are ending the three day underperformance window. If history is any guide, then stock prices should see better returns in the days ahead.

Disclosure: Long SPXL

6 thoughts on “An island reversal sell signal?

  1. Interesting analysis. Thank you. I would point out that volume by price might indicate quite a bit of support in this zone, and price action looks more indecisive than anything, imho, not bearish. Also, my anecdotal observation is that the middle candle in an island usually has a longish tail, not the indecisive spinning top (or whatever you call it) that we have in this instance. Finally, weekly chart seems more inclined to confirm consolidation in move up from prior week, rather than the beginning of a possible correction. Of course, that could change. Post-finally, looking at hourly time frame shows buying volume since the possible island reversal. In my very humble opinion, I’m not sure the weight of evidence confirms the possible reversal. I’d love to hear your take.

  2. As I had mentioned in my previous post you always need a confirmation by price and volume to make a final decision. These indicators serve as guide posts. Price and volume are final arbitrator.

    “I would now watch the previous lows 2264 on the S&P 500 futures and 1339 on the Russel 2000. A decisive break of those levels with increasing volume would be intermediate bearish. Remember, we have not had a 5% correction since about a year ago.”

  3. When Alice went into Wonderland, down is up and up is down. Trump World is Wonderland in the Twilight Zone.

    We look for logical signposts. Is there any?

    This Whitehouse is super American business friendly unlike anything any living investor has experienced. If Congress goes along with this after the first 100 days, this market will take off regardless of the chart pattern at the time.

    Blue chip investment tip. TTWS is the Buyback ETF. When the Congress moves to allow repatriation of huge overseas corporate cash, I expect buyback oriented stocks will outperform and this ETF captures this. Both Trump and the GOP Congress campaigned for this. It has outperformed the market since the election only by about 3%. I expect a lot more when actual bills are introduced and investors wake up to the consequences. My clients will own a lot of this.

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