Island Hopping…or Topping

For reasons you will understand by the end of this writing, I am going to file this away as an educational post more than anything else.

The SPY and DIA (ETF’s for the S&P 500 Index and Dow Jones Industrial Average) are both sporting bearish island top reversals on their daily timeframes. The  “island” on the Dow ETF is more proper and pronounced, given the fairly-aligned gaps on either side of the island. So, I am going to focus on that chart.

The chart pattern has indeed confirmed lower, with all of the critical elements met:

1. A prior uptrend leading up to the island;
2. A noticeable gap higher, which leads to;
3. An island (several days up to several weeks or months) of longs now trapped, when;
4. A gap lower commences on heavy sell volume on the other side of the island; 
5. The gaps on either side of the island share some or all of the price range.

Beyond that, the island lasted for roughly a full month, if not more, which yields a plethora of trapped longs if this is the real-deal top, theoretically left starving on the deserted island for next several quarters.

However, Bulkowski’s performance backtest of the pattern yields awful results, meaning even a confirmed island reversal pattern is not historically very reliable. Thus, it may be more of a novelty than anything else. And I suppose the truly surprising result would be to see this island actually prove true as a multi-quarter top.

Furthermore, we know the Dow has been beaten-down and will likely try to muster a bounce in some names like Home Depot this week.

In order to negate the pattern, I would consider a close above $153 and especially $155 to alleviate most of the angst of longs trapped on the island.

But, make no mistake, regardless of the backtests this pattern has confirmed and the psychology behind it is in play, with trapped longs still on the island.

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