Exhaustion gaps are like the last glory that a stock experiences before price collapses. It usually happens in a stock that is hot and chased by many. At the end of the bullish run up, the stock gets so in demand that it gaps up. But because the upward move is no longer sustainable, the stock collapses after the appearance of this gap. That is why we call this kind of gap an exhaustion gap. The stock gets exhausted and price drops.
So what are exhaustion gaps? Is there a set of criteria that needs to be satisfied? While there are different textbooks that may require different criterias, I would just like to put exhaustion gaps as "gaps that happen after a period of quick run up". Here are some things to look out for:
I don't like to fix a set of criterias for this type of gap to satisfy but when I see a gap that happens after it runs up too much, it's best to start thinking whether they are exhaustion gaps or not. If you are in the stock, perhaps its also time to consider taking some profits off the table or just the sell the entire thing.
The chart of ADI above shows how an exhaustion gap looks like. Initially there was a first gap as the stock forms a double bottom type of chart pattern. Then there was a rapid run up in price. As the stock gets hotter and gets more mention in social media and the news because of its nice run up, it is sought after by lots of investors and traders.
This causes the stock to gap up. However, the price advance was not sustainable and the stock quickly closes way down from its opening price. The next day, the stock trades even lower and at this point, the trader suspects that the gap in the previous session is an exhaustion gap.
See how the stock gave back almost all its gains in a short period of time after the appearance of the exhaustion gap. If you were playing this stock, some knowledge of the exhaustion gap would have enabled you to exit the stock a bit early and capture a significant portion of the profit.
In fact, when I see too many gap ups in my stock I tend to want to take at least 1/3 of my profits off the table even before the actual confirmation of the exhaustion gap.
BBT is an example where the exhaustion gap is not so obvious. The stock had a really nice run up in price from November to February. It consolidated awhile and actually looks like it is making a breakaway gap that may send it higher. However, the stock quickly close the gap, drops below its 20 MA, drops below its 50 MA and even broke an uptrendline. At this moment, the technician should start to think whether the gap is an exhaustion gap or not.
The last price gap up is nothing more than excitement from the public. The price rise was unsustainable and therefore the stock collapses.
CF Industries is another good example of an exhaustion gap. You can see how the stock had a nice run up and then the last gap up was unable to make the stock go any higher. Instead, the stock traded sideways and formed a box type of pattern. The stock gap down below the box and this made a pattern called an island reversal. The stock then proceeded to drop from there.
COP is a good example of where you can combine exhaustion gaps with chart patterns. After a nice run up and some gap ups, the stock made one last gap up which just can't make the stock go any higher. The stock formed a descending triangle type of pattern and broke lower.
IP is also another good example of exhaustion gap. The stock experience a failed breakout pattern combined with an exhaustion gap. Breakout patterns are suppose to send the stock higher over the course of time but the last gap up was merely an excited public that got word of the stock and chased it higher. The next day, the stock formed a dark cloud cover candlestick pattern and the stock proceeded to have a nasty drop lower.
While it is difficult to ascertain whether a gap up is an exhaustion gap the moment it happens, it still can give the smart trader some hints if the stock is topping out. Whenever price moves too fast too soon in one direction, it is always good to ask yourself, should I go the other way. The public is always right in the middle but wrong at both ends.
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