Gap downs are good for bull markets, but island tops are not. The SPY gapped well below the low of the last 3 days of consolidation, and if you look closely you’ll notice that the consolidation days started with a gap up. As a result, the SPY, technically has an “island top” pattern which can be a very bearish pattern. However, I don’t think it’s a very bearish sign right now because the best island tops have much bigger gaps, and sometimes gap downs are good for bull markets. Friday had several characteristics of a bullish gap day.

Before I look at Friday in particular, here’s why I think gap downs are good for bull markets.

1. They test the resolve of the bulls. If the market rallies from the gap then you know where support is, and that the bulls are not weak.
2. They often flush out weak bulls, and attract short sellers, both of which provide an extra boost to the bull move for days after the gap when it doesn’t lead to a break down.
3. They provide lower entry points for the bulls, which builds confidence as the market moves higher.
4. They enable the savvy trader to identify which areas of the market are the leaders vs. those losing momentum.

The SPY had a significant gap down on Friday, but the QQQ, IWM and DIA did not. The next indication that the gap was not going to be bearish came when the SPY broke below its 30-minute Opening Range at about 10:15. While the SPY was making a new low for the day the QQQ was near its high and IWM was consolidating. This divergence is a good pattern for expecting exactly what happened next, all the markets rallied with QQQ leading the way.

Looking at the Modern Family’s daily charts you’ll see that the current leader, SMH, actually gapped up and the continued higher. The weaker member of the family, KRE and XRT did gap down but they both put in their low of the day in the first 10 minutes.

By the end of the day the leader, SMH closed well into new high territory, the IWM closed over the prior high and a significant daily resistance level, 142.30, and the rest of the family members closed strong or within their consolidation ranges.

Friday’s low is significant because of the island top pattern, and a break below it would be more bearish than a normal day’s low. However, the SPY seemed to be trading on its own lonely island while forming this pattern, and from my point of view it doesn't look too bad.

I’d be more inclined to use it as a stop to buy the SPY’s against expecting the gap down is an opportunity not the bearish omen it’s typically seen as.