Ever since Steve Nison introduced Japanese candlestick patterns to the West, traders have used candlestick chart patterns to make trading decisions. Stock prices display patterns over time that tell us something about the risks and opportunities in the market. There are two kinds of chart patterns: reversal and continuation patterns. Reversals signal that a trend is shifting, whereas continuation patterns signal that a pattern will go on. Chartists have found that the island gap is one of the most powerful reversal patterns in the market. 

What is the Island Gap?

The island gap frequently occurs in chart patterns. The name refers to the fact that there is a price gap separating trading periods, typically days, on a chart. Most people interpret that gap as being meaningless, believing that the price trend will continue despite the gap. However, the pattern tells us that the previous price trend may reverse. Island gaps are more frequent on stock market charts than on forex charts. They are very transient signals, so traders must act fast and respond to them. Island gaps are some of the most reliable chart signals you can find. Although you can scale a chart up and down, the best timeframe to use when working with island gaps is a 15-minute chart.

This pattern is even more potent because it typically occurs in a definite price trend, so being able to pounce on the signal will potentially earn you rich rewards. In addition, you want to look at volume data to tell you just how strong the previous trend has been and to see if there is any sign that it is weakening. 

How an Island Gap is Formed

Because the island gap is a reversal pattern, it can appear at the top or the bottom of a price formation, although it appears more frequently on tops. An island gap has five features:

1. A long price trend before it.
2. An initial gap.
3. A group of price periods trading within a narrow range. 
4. Increasing volume toward the gap and through the island, concerning the previous trend. 
5. A gap that creates the price island separates it from the previous trend. 

Source: Kien Thuc Forex

An Island Gap Top Pattern

This pattern occurs when an island gap appears at the top of an upward price trend and then a down gap in the third session, although the subsequent down gap can appear in the fourth or fifth session. 

The key thing is that you observe gaps formed in opposing directions. 

An Island Gap Bottom Pattern

This occurs at the bottom of a bear market. As a result, you will see a down gap and an up gap in the next session. After this, the price trend will typically rally sharply. 

Bet Size

The first thing you need to do is to have an appropriate bet sizing strategy. The best bet sizing strategy is the Kelly Criterion. The Kelly criterion is at once highly risk averse, and the bet sizing strategy gets traders to their financial goals in the quickest amount of time. The Kelly criterion can be radically simplified to this: edge/odds, where edge represents how much you think you can make, and odds represents what the market will pay if you are right. The criterion says if you don’t have an edge if there’s no signal saying you can invest and make money, don’t invest. The edge/odds ratio tells you what fraction of your wealth to invest, given the opportunity in front of you. 

You have to calculate your edge by determining how much you think you can make from taking advantage of the signal. Edge is information about something you know that nobody else knows or something you interpret better than everyone else. That’s a high bar, so you have to be clear that there is an opportunity in front of you and that the signal is strong. You want to combine the island gap signal with other metrics to ensure that you do have a strong investment thesis. 

Limit Losses

Island gaps are not a trading strategy. They are a trading signal. Signals do not always turn out to be true. We know from information theory that signals can be noisy, creating a risk that we do not get the appropriate message behind the signal. 

Given the uncertainty behind signals, you need to develop a coherent trading strategy. The first rule of trading is: don’t lose any money. You have to keep this in mind. You see, losses are more impactful on portfolios than gains. Here’s an example: if you lose 10% of your capital, you need an 11% gain to get back even, if you lose 50% of your capital, you need a 100% bounce, if you lose 80%, you need a 333% gain, and if you lose 99% of your capital, you need a 1,000% gain. You see, losing hurts, and your trading strategy has to be geared toward avoiding losses. It’s a myth that you must chase risks to earn high rewards. 

So you have to be aggressive in cutting out losing positions. if it turns out that you have misread the signal, cut your losses quickly. You cannot shillyshally. So you want to have a tough and tight stop loss. Remember, it’s hard to recover from losses. Some losses are impossible to recover from. Unfortunately, many traders do not realize this and allow their losses to rise above a sustainable level. Your job isn’t to be right, it’s to make money. 

I recommend limiting your losses to 10% because that’s a level anyone can recover from. Beyond that, you’re asking for a miracle to recover. Some people are willing to tolerate higher losses, although I think people who do so typically tend not to realize that it’s so hard to come back from losses. Although island gaps can be very powerful signals, remember, signals are noisy.