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This week we have seen the formation of a classic island reversal on CBA:ASX. An island reversal occurs when a market gaps in the direction of the trend, has between one and a few days of price action past the gap and then gaps back again to where it was prior. This in effect creates an “island” of price bars on the other side of the gap. Take a look at Chart 1 to see the current gap and island reversal on CBA.
Chart 1: Daily Bar Chart of CBA showing Island Reversal Pattern
click to enlarge
Traditionally an island reversal is a strong signal for a change in trend. As many traders of the SPI200 futures contract would know, if it lines up with time and price analysis an island reversal is a favourite signal. Take a look at the March 2003 low on the SPI, or the recent April 2010 high. We can see that these were the end of strong trends in one direction and the start of strong, tradeable trends in the other direction. Chart 2 shows us a period on the SPI where we saw plenty of these turns.
Chart 2: Daily Bar Chart of AAI-SpotV with Island Reversal Pattern
click to enlarge
My knowledge of the SPI lead me to question the strength of this particular setup on CBA. How would I be confident that this was a strong turn in the market and not just a retracement against the trend? The answer is, as always, backtesting. Going back through the history of CBA I found over a dozen examples of island reversals. Interestingly, they weren’t at the same points that the SPI exhibited that signal in March 2003 and April 2010, but there was a terrific example at the January 2009 low.
Of the island reversals that I studied, seven of them became turns in the monthly swing chart, giving us a strong turn and thus a potentially profitable trade. The rest put a turn in the weekly chart; all but one still giving the chance for a profitable trade. To do this yourself you should not only highlight the island reversal patterns but look at the price and time analysis associated with the turning point to determine how confident you would have been to trade it.
So what does this mean for CBA at present? In my most recent Safety in the Market article I pointed out the balancing of time in CBA, but I didn’t go into the price reasons we might expect a turn. Whilst we have seen the island push past the highs in August and September last year, the market has gapped back below them and only the island is above. There is a lot of price pressure above this island. Take a look for yourself at the Jan 09 to April 10 ranges resistance card, the 09 Lows Resistance card, the Mar 00 lows resistance card, the Square 144 from April 10 high and the Square 144 from the 09 low. Combine this with the smaller picture price analysis in Chart 3 and we have quite a price cluster at this point.
Chart 3: CBA Daily Bar Chart with Price Cluster
click to enlarge
Are we just seeing a retracement against the trend at the moment? Will the market push through this price resistance to form a third leg up? With that much price resistance, if the market does push through it will be looking very strong to the upside, but whilst ever the island remains I am looking down.
It’s the journey
Lauren Jones
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