How to Deal with Exhaustion Gaps in Trading Price Bars
A gap is one of the most important special trading price bar configurations. A gap is a major, visible discontinuity between two price bars on a chart. Exhaustion gaps occur at the end of a trend, signaling that the party’s over. Volume is usually low.
What’s exhausted is the news that propelled the security up in the first place and the energy of the early buyers. An exhaustion gap is usually followed by a reversal.
Here’s how it works. This example is an exhaustion gap at the end of an uptrend, but the mechanics are similar for a downtrend exhaustion gap, as well. When you see a gap up in an existing uptrend and volume is low on that day, you have to wonder why the gap appeared. Volume tells you that buyers aren’t pounding on the sellers’ doors to get the security.
Presumably some greedy seller is out there, along with one last fool who’s willing to pay a gap-worth more than the last trade. The buying frenzy is over, but the buyer doesn’t realize it. He fails to see that there are a lot of offers and few bids. In short, everybody who wanted to buy has already done so. But somebody has to be the last buyer, and this particular one got taken to the cleaners — in the form of the gap. When he turns around and tries to unload his recent purchase, he finds no buyers, at least no buyers at a profit to him, and has to dump the security at a loss.
You can distinguish an exhaustion gap from a runaway gap by looking at volume, which is usually low at an exhaustion gap. Anytime you see wild new highs (or lows) that aren’t accompanied by wild new high volume, be suspicious of the staying power of the move. You can exit altogether or move up your stop-loss order.