Rectangular & Island Reversal Patterns

In technical analysis, recognising reversal patterns can give traders a significant edge by helping them identify potential turning points in the market. Two common reversal patterns that traders often rely on are the Rectangular Reversal Pattern and the Island Reversal Pattern. While both indicate an upcoming change in the direction of the trend, they form differently and signal reversals in distinct ways.

In this chapter, we’ll break down both the Rectangular Reversal Pattern and the Island Reversal Pattern, exploring how they form, what they signal, and how traders can effectively use them. Let’s start by looking at the Rectangular Reversal Pattern, which is characterized by a prolonged period of consolidation.

1. Rectangular Reversal Pattern: Consolidation Before the Turn

The Rectangular Reversal Pattern is a range-bound pattern that forms when the price oscillates between a clear support and resistance level for a prolonged period. It indicates that the market is in a state of indecision, with neither buyers nor sellers gaining control. Eventually, the price will break out of the rectangle, signalling a reversal in the trend.

This pattern is typically seen after a prolonged uptrend or downtrend and signals that the existing trend may be losing strength.

How to Spot a Rectangular Reversal Pattern?

• The price moves within a horizontal range, forming a rectangle shape as it repeatedly hits the same support and resistance levels.
  

• The pattern forms after a significant uptrend or downtrend, signalling a period of consolidation.
  

• A breakout from the rectangle (either above the resistance or below the support) confirms the reversal.
  

Reference of Rectangular Reversal Pattern

The Rectangular Reversal Pattern provides a clear visual cue that the market is undecided. Once the breakout occurs, traders can confidently enter a trade in the direction of the breakout. Let’s see how this works with a real-world example.

Example: Rectangular Reversal in Infosys

Image Courtesy: Tradingview

Imagine Infosys has been in a steady downtrend for several months, reaching a low of ₹470. The stock then enters a period of consolidation, bouncing between ₹470 (support) and ₹520 (resistance) for several weeks, forming a Rectangular Reversal Pattern. Eventually, the price breaks above ₹520, signalling a bullish reversal. Traders may choose to buy the stock at this point, anticipating a further decline.

Now that we’ve covered the Rectangular Reversal Pattern let’s move on to the Island Reversal Pattern, which offers a more abrupt and dramatic shift in market sentiment.

2. Island Reversal Pattern: A Dramatic Shift in Trend

The Island Reversal Pattern is a strong reversal signal that forms after a gap in the price, either upward or downward. It occurs when the price opens with a gap in one direction, consolidates for a few days or weeks, and then gaps in the opposite direction, creating an “island” of price activity that is isolated from the rest of the chart.

This pattern is often seen after a significant trend, signalling that the existing trend has come to an abrupt end and a sharp reversal is about to occur.

How to Spot an Island Reversal Pattern?

• The price gaps up or down, forming a gap between the previous price movement and the current price.
• The price consolidates for a period, forming the island of price activity.
• A second gap occurs in the opposite direction, completing the pattern and signalling the reversal.

Reference of Island Reversal Pattern

The Island Reversal Pattern is unique in that it involves two gaps—one to start the formation and one to end it. The second gap is a strong signal that the market sentiment has shifted and a reversal is underway. Let’s explore an example of how this pattern appears in the market.

Example: Island Reversal in Tata Steel

Image Courtesy: Tradingview

Imagine ONGC has been in a downtrend, with the price falling steadily to ₹113. One day, the stock gaps down, opening at ₹110, and begins to consolidate around that level for the next several days, forming the island. Suddenly, the stock gaps up to ₹11, completing the Island Reversal Pattern. This signals a bullish reversal, and traders may enter a buy position, expecting the price to rise further.

The Island Reversal Pattern is often seen as a stronger and more abrupt reversal signal compared to the Rectangular Reversal Pattern, which typically forms over a longer period.

Confirming Rectangular and Island Reversal Patterns

While both the Rectangular and Island Reversal patterns are strong indicators of market reversals, traders often seek confirmation before entering a trade. Here are some methods for confirming these patterns:

• Volume: For both patterns, a spike in volume during the breakout or gap confirms that the reversal is valid. In a Rectangular Reversal, increased volume on the breakout above resistance or below support strengthens the signal. In an Island Reversal, the volume should increase significantly during the second gap, confirming the trend reversal.

• Moving Averages: A breakout that occurs above or below key moving averages (such as the 50-day or 200-day moving averages) can provide additional confirmation of the trend reversal.

• RSI (Relative Strength Index): The RSI can help confirm the strength of the reversal. In a Rectangular Reversal, an overbought RSI near the resistance level strengthens the case for a bearish reversal, while an oversold RSI near the support level adds confidence to a bullish reversal.

How Traders Use Rectangular and Island Reversal Patterns?

Traders use both the Rectangular Reversal Pattern and the Island Reversal Pattern to identify opportunities to enter or exit trades at key market turning points. Here’s how they typically approach these patterns:

• Rectangular Reversal: Traders often enter a position when the price breaks out of the rectangle. A break above the resistance signals a bullish reversal, while a break below the support signals a bearish reversal.

• Island Reversal: Traders enter a position when the second gap occurs, confirming the reversal. A gap up signals a bullish reversal, while a gap down signals a bearish reversal. Due to the strength of this pattern, traders often set tight stop-loss orders to manage risk effectively.

Conclusion

Both the Rectangular Reversal Pattern and the Island Reversal Pattern are valuable tools for identifying key turning points in the market. While the Rectangular Reversal is characterised by a prolonged period of consolidation before a breakout, the Island Reversal offers a more abrupt signal with two gaps that signify a dramatic shift in market sentiment.

By combining these patterns with volume analysis, moving averages, and technical indicators like the RSI, traders can confirm the strength of the reversal and make more informed trading decisions. Whether you’re looking for a gradual or sharp change in trend, these patterns provide powerful insights into potential market reversals.

In the next chapter, we will explore an Introduction to Technical Indicators: The Key to Analyzing Market Movements, which helps traders use mathematical tools to interpret price data and make informed trading decisions.