Island Reversal ?

Today's action in US equities started strongly with a >1% gap in the SPY, and looked set for a trend day until sellers came in near the close and drove it to close within the bottom 10% of the day's range. Bearish chartists are certainly rubbing their hands with glee with thoughts of island reversals in their minds, especially after the vertical run up that we have experienced in the past weeks. Let see if we can gain some clue from the past action on days that start with an open gap of >1%.

Using data going back to 1993, we had163 instances of days with a SPY open gap of >1%, 53 of which (35.5%) were immediately closed on the same day (price trading below the previous close or pre-opening gap price). As we now know that was not the case today, we can narrow our focus on the rest of the sample and see what tomorrow may bring. As it turns out, the probability of the gap being closed on the second day is only about 11% (12 of 105 cases, with the average loss being 1.7%), so the odds of the formation of an 'island reversal' signaling buying exhaustion just does not seem high. If we further narrow the sample down to those appearing after a period of strength, as was the case today which marked a monthly high, we find that the bearish case diminishes even more. Within our sample, 22 of those days also marked monthly highs, out of which only 1 experienced a gap fill on the second day. In summary, historical evidence makes a bear case very hard to build, at least for the immediate trade going into Friday.

Having said that, one should also keep an eye on the breadth of the market, which might be showing signs of tiredness as evidenced by only 4 sectors managing to close above the monthly range despite the broader index managing to do so.