An easy-to-see, obvious reversal is the Island Reversal. It provides a dramatic reversal in that the enthusiasm that sent a price in a particular direction is countered with the same enthusiasm going the other way. In the example of Orbital Sciences Corp. ORB, Figure 29, the up-trend can be easily seen. At the top, after the buying enthusiasm created a long bullish candle, the price gaps up away from the previous trading. This really demonstrates that the enthusiasm had reached an apex.
But upon inspecting the formation that it made, a long-legged Doji, the Candlestick investor should have been alerted to the indecision that was illustrated during this gap up. The following day did not show any evidence that the buyers were still present. This would have been further warning that the blow off top was in place. Finally the gap back down illustrates the great enthusiasm to get back out of the stock. This is an Island Reversal, usually very accurate and powerful.
Figure 29 – Orbital Sciences Corp. An Island Reversal doesn’t have to be a quick move. Note in the Circuit City chart, Figure 30, how the gap down was countered with a gap up over six weeks afterwards. This formation indicates to the long-term investor that a new long-term trend has started. The gaps on both sides of the bottom trading area make the Island Reversal an easy-to- see situation.
Figure 30 – Circuit City As long as the gaps remain unfilled, the trend should remain up.
Bad News Gaps
The ultimate poop trade! You just recently bought a position because of a very good bullish signal. All confirmation is positive, it moves up nicely the first day. THEN, the dreaded news! The company issues an earnings warning, the SEC announces a surprise audit, a contract gets cancelled. Whatever the news, the price drops 20%, 30% or greater. The question is, “What to do now?” Do you sell the stock, take a loss and move on? Do you trade it at the new levels? Do you hold and/or buy more at these levels? What is the best course of action?
Traders and long-term investors will have completely different outlooks. The trader bought the stock a few days back, due to specific parameters for making that trade. He should consider liquidating the trade immediately and move his money to better probabilities. The reason for putting on the trade, for a short-term trade, has completely disappeared after the massive down move. The longer-term investor has a few more analytical options. They may want to hold the position because the candlestick formations indicate that the price will move back up or liquidate because the Candlestick signal shows further decline. Reading the signals becomes an important element in knowing what to do in a “bad news” situation.
A “bad news” gap down has a multitude of possibilities after the move. The prior trend gives you valuable information on how to react to the move. Of course, the news is going to be a surprise or there wouldn’t be the gap down. Analyzing the trend prior to the move gives you a good idea of how much of a surprise the announcement or news bulletin is. For example, IBM, Figure 30, recently reported lower earning expectations. The price gapped down. However, you have to analyze whether this news was a complete surprise or whether the gradual decline in the stock price was anticipating the coming news. As can be seen in the IBM chart, the price had been declining Figure 30 – IBM for three months before the actual news was announced. The smart money was selling from the very top, months ahead of time. It was the diehards who held on until the bad news was reported. As the chart shows, the final gap down produced a long legged Doji, indicating massive indecision. From that point the buyers and the sellers held the price relatively stable for the next few weeks. This now becomes one of the few times that a technical analysis has to revert back to fundamental input. Unless you believe that the markets in general are ready for a severe downtrend, consider what the chart is telling you. The price of IBM stock was reduced from $125.00 per share down to $87.00 per share. The last down move produced a Doji. The price has not moved from that level for two weeks.
Now let’s look at the fundamental input. IBM, a major U.S. company, well respected, known to have excellent management. And like any other quality company, it has made marketing or production mistakes from time to time through the years. The announcement made that knocked the price down, whether it was a earnings warning, shutting down a product line or whatever, the factors that were announced as the result of the problem did not surprise company management. They knew that there were problems well before the news announcement. Being intelligent business people, the management of IBM was aware of the problems and had been working on the solutions months before they had to announce. When the announcement was made, probably many strides had been already taken to correct whatever problems caused the price to drop. For the long term investor, it would not be unusual to see the price of IBM move back up to at least the level where it last gapped down, approximately $100. This still provides a 15% return.
You can chart your own course through common sense analysis. Watching for a Candlestick “buy” signal gives you the edge. IBM is not going out of business. Who was buying at these levels when everybody was selling? The smart money! Are the professional analysts of Wall Street recommending to buy at these levels? Probably not! But watch the price move from $85.00 back up to $95.00, then you will see the brave million dollar analysts say it is time to buy. Practical hands-on analysis, being able to see the “buy” signals for yourself, will keep you ahead of the crowd.
BKS, Barnes and Noble, Figure 31, has a completely different scenario. Notice it was in an uptrend, just about ready to break out to new highs when it had bad news reported. With the trend being up prior to the announcement, it appears that the announcement came as a complete surprise. This should imply that if you are in the position, get out immediately. There will be no telling what the reaction will be. In this case, the sellers continued to sell on the big down day after the announcement.
Being out of the position now gives you a better perspective as to what the news will do to the longer-term trend. It took only the next day to see a Doji to be prepared to get back into the stock. For the longer-term investor, this becomes a good place to start building another position. The buyers start becoming evident on the next day after the Doji. A purchase at this level creates a relatively safe trade. A stop at the lows is a logical point for getting out. The rationale being that if those levels did not support, the sellers were still in control. Figure 31, BKS Barnes & Noble
On major gap down days, major being a 20% down move or more, there is always the initial 30 minutes of churning. The traders who were short start buying to cover, while the sellers are unloading. After that period, the buyers or the sellers will start to overwhelm the other side. This is where an immense amount of information will be revealed. If the price starts acting weaker, the news still had sellers participating. If the price starts up, that would indicate that the news scared out the weak holders and did so at the level where the buyers felt it was oversold, and they stepped in immediately to buy the bargain. This should reveal to the Candlestick investor that the white candle forming represents a buying level. Hold on to the position for awhile. It is not unusual after a major gap down to see the price move back up to the area from where it gapped down. This would occur over a six to twelve week period. Still not a bad return, 20% to 30%, over that time frame.