Hearing That Island Music

http://www.youtube.com/watch?v=wSNxu_405Mk

Mike (@APGovernment on Twitter) wanted to take a look at the “island top” and the “island bottom” chart patterns.

To reiterate the elements of an island top:

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.

The island bottom is pretty much those same elements flipped over.

I did an educational post on the island top in August for the Dow Jones Industrial Average ETF (DIA), giving the strong caveat that the pattern did not test particularly well, historically.

As I said:

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.

Nonetheless, Mike’s question comes at a very interesting time. @PeterLBrandt noted on Twitter that the daily chart of the S&P 500 futures was sporting a potential island top reversal, with this evening’s gap lower in the futures versus the September 16th gap higher (which then created the “island” of longs).

Applying this evening’s futures chart, below, to the elements of the pattern above, the gaps on either side of the “island” do not appear to share some or all of the price (a tick or two, at best). However, the gap on the right side of the island is below the left side, perhaps indicating an unusually weak situation.

Putting all of the technical elements to one side since, again, the historical efficacy of the island top pattern is suspect, just looking at the chart below you can see the psychology behind the pattern is what intrigues me more than anything else.

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