The OIH Island Gap

06/30/06 03:59:53 PM

by David Penn

A gap up in oil service stocks leads to a low-volume island consolidation and a gap up breakout.

Security: OIH
Position: N/A

I've written frequently of late that both stocks and commodities were moving into a time frame during which significant intermediate-term lows were likely. My conviction on this score comes courtesy of the cycles analysis of Tim Wood (cyclesman.com), as well as the general, technical "look" of the charts. One example of how this low has played out in the nexus of equities and commodities is in commodity stocks like those in the oil service HOLDRS. These stocks—along with the rest of the market—bottomed in mid-June, bounced and, after a brief consolidation period, began again to move higher.

FIGURE 1: OIL SERVICE HOLDRS. There was plenty of reason to believe that the oil stocks were biased toward the upside.

Graphic provided by: Prophet Financial, Inc.

I wrote that there was a potential for a significant move once stocks in general made their mid-June bottom (see my "Launching Pads," June 28, 2006; Traders.com Advantage). At the time, I was direction-agnostic, with an eye for the downside. However, as we can see in the charts of the OIH in Figures 1 and 2, there was plenty of reason to believe that the oil stocks at least were biased toward the upside.

How so? The evidence was in the gap up that occurred two days after the closing low for the decline was in. The gap up did not occur on overwhelming volume. In fact, relative to days immediately preceding the gap up session, volume on the gap was lighter rather than heavier. For many, this session was not convincing enough and the selling that developed almost immediately afterward was testament to that. However, the selling never brought the OIH to a new low for the decline, leaving plenty of room for the possibility that the positive divergences accurately marked the bottom.

FIGURE 2: OIL SERVICE HOLDRS

Graphic provided by: Prophet Financial, Inc.

You could actually argue that the pattern in the second half of June is an island gap with a continuation gap four sessions later. Prices gapped up into the consolidation, retreated over the next five days, but failed to set a new low, then gapped up again into another short-term consolidation before gapping up once again toward a 50% retracement of the May–June decline.

Island gaps are not typically referred to in the literature compared to other sorts of gaps—especially island reversals. It could be said that the island gap is an island reversal gap that didn't reverse. In any event, the size of the island created is one clue as to the initial distance the market is likely to travel from the gap. Here, an island gap of more than 10 points suggests a rally to the 154 area once that 10 points is added to the value at the highest point in the island gap formation.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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The OIH Island Gap

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