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Stranded on an Island

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Perhaps when you were studying the charts accompanying last week's article on exhaustion gaps, you noticed something unusual on Priceline's chart.

Annotated Daily Chart of PCLN:

Thomas A. Meyers explains in THE TECHNICAL ANALYSIS COURSE that island reversals occur when gaps at about the same horizontal level isolate a portion of the chart from the rest of the chart.

Both Meyers and Martin J. Pring, writing in TECHNICAL ANALYSIS EXPLAINED, note that the part of the chart that's isolated by the two gaps is often part of a larger formation, such as the head on a head-and-shoulders formation.

Looks serious, doesn't it, this island reversal? Turns out, it's not always a sign of a major reversal. In fact, both authors warn that, by itself, it can't be deemed a sign of a major reversal. Meyers comments that while prices may retrace the move immediately leading into the island formation, a major portion of that retracement may already be underway by the time the second gap occurs. In fact, that $16.12 intraday low on the far right-hand side of the PCLN chart was to be a low that has never since been violated although it was retested with a $17.42 low in August, 2004.

Annotated Daily Chart of ARRS:

The charts shown so far include island formations in which months' worth of the chart were isolated by the gaps. That isn't always true.

Annotated Daily Chart of AAPL:

Annotated Daily Chart of SOV:

As should be obvious from the SOV chart, island reversals can also occur at market bottoms as well as the tops shown on the previous charts.

And they can, despite the caution that they don't always do so, signal a major top or bottom. In all the cases shown on these charts, an island reversal has produced a tradable move in the direction of the reversal, but not necessarily a long-term move. A breakaway gap forms the second of the gaps that isolate an island, and prices often don't test a breakaway gap immediately.

Unfortunately, unless you find a gappy stock--usually a low-volume stock that tends to get pushed around a lot and gaps up and down--you don't find many island formations. I would avoid them when they're occurring in an illiquid, little-traded stock, but when they occur in a more liquid stock, they present the possibility for a tradable move. An immediate retracement of the gap, however, signals that something has gone wrong and that your island is no longer an island, and, perhaps, that the anticipated retracement or reversal is no longer quite so likely.

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