Tyson Clayton – Senior Currency Strategist at Market Traders Institute – offers a timeless lesson on how to identify price gaps and trade the resulting island reversals in an effective manner.
Tyson will help you learn his time-tested way to trade these reversals with Fibonacci retracements. To know more about the systems, tricks, and strategies that he uses to target profitable trades, you can sign up for his free weekly newsletter here.
“Island Reversals” are one of the common chart patterns that traders follow to track price gaps in the market. The problem? Many investors don’t trade it effectively. .
Today, we will be talking about what these gaps in the market are, how they are formed, and how one can learn to effectively trade the resulting Island Reversals for potentially successful trades.
Here we go…
First things first, let us quickly go over what gaps and island reversals mean…
Gaps
A gap is nothing but an area of discontinuity in a security’s chart. Meaning, the security’s price either rises or falls from the previous trading day’s closing price with no trading occurring in between. The idle area on the security’s chart between these two prices is called a gap.
Gaps typically occur in volatile markets where there are larger price movements where the price of a stock or any other financial instrument moves sharply up or down, with little or no trading in between. And this resulting gap in the normal price pattern is what one can look to trade for.
An example of this is a company reporting lower than expected numbers which leads to a gap down opening in its stock on a particular day. Similarly, in the Forex market, economic data releases can widen bid and ask spread for a currency pair which further leads to gap up or gap down opening.
Island Reversals
An island reversal is formed when a cluster of trading days is isolated by two different gaps in the price action of a security. Simply put, an island reversal pattern is a chart pattern that involves a gap in price, consolidation, and then another gap in price in the opposite direction thereby creating an island of candles.
These gaps and island formation indicate a sudden change in the direction of the current price trend. This shift helps traders predict future price direction for a stock or currency pair and determine how they want to place their trades.
In all, the island reversal pattern indicates a possible reversal of a prevailing trend.
With that, let’s try to understand how we can learn to trade these reversals in an effective way…
Trading the Island Reversals
As per Tyson Clayton, Senior Currency Strategist at Market Traders Institute, there’s more to trading these reversals than just placing trades in the reverse direction.
You see, whenever we see a gap in price, there’s a very high probability that the gap is going to be filled. Meaning, if there’s a gap up opening for a stock, it will be followed by a gap down. And traders can use this indication to direct their trades to play the trend and potentially profit from it.
However, here’s an interesting bit – the market has a tendency to play some more patterns before the above gap is filled. What Tyson means here is that this gap is typically not filled in immediately. Instead, the gap tends to come back to the previous pivot area and moves up/down initially before it puts in its reversal.
Once we know this trend, we can be more strategic about placing our trades while trading the island reversal pattern and can potentially make the most out of it.
Here’s an example of how this pattern can look on a chart…
Price Trend Following a Gap for AAPL
Source: MTI, SmartTrader
Have a look at the blue, yellow, and the red lines in the image above. The area between the blue and yellow line represents a gap (as there’s no price movement taking place between these levels).
Now, as per the reversal theory, the price should make an attempt to fill the gap. However, what it initially does is it goes up to the previous day’s high which is at the horizontal red line placed on the chart. So, anyone trying to trade the gap and reversal pattern here would have lost if they were purely anticipating an immediate reversal in price.
So, the point here being is that reversals in price don’t immediately follow the gaps but may test some pivot levels or prior day’s high/lows before they put in a complete reversal to fill the gap. And this knowledge can help you trade the island reversals in a more strategic and potentially profitable way.
Another interesting way to trade the Island Reversals is to combine them with Fibonacci levels. For more insights, you can watch this short video, where Tyson demonstrates a trade on AAPL using his Island Reversal strategy coupled with Fibonacci levels.
You can also download his FREE e-book – The Ultimate Indicators Guide. This expert guide shares Tyson’s favorite tools that have helped this veteran pro find some of his most profitable trades.
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