Exhaustion Gap

What Is an Exhaustion Gap?

An exhaustion gap is a technical signal marked by a break lower in prices (usually on a daily chart) that occurs after a rapid rise in a stock's price over several weeks prior. This signal reflects a significant shift from buying to selling activity that usually coincides with falling demand for a stock. The implication of the signal is that an upward trend may be about to end soon.

Understanding an Exhaustion Gap Signal

There are many authors and analysts who have written about exhaustion gaps. The curriculum for the CMT Association, the professional association for technical analysts, specifies that the exhaustion gap "occurs at the end of a sustained and volatile price move and confirms the reversal." This definition turns out to be useful in understanding the dynamics associated with this price-pattern signal.

The principle behind an exhaustion gap is that the number of likely buyers has diminished and sellers have aggressively stepped into the market. The buyers may be largely exhausted implying that the upward trend is likely about to stop as sellers take profits from a previously extended rise in the price of the stock. The exhaustion gap has three particular features.

1. Several weeks or months of upward trend in the share price of a stock.
2. A sizable gap between the lowest price of the day previous and the highest price of the most recent trading day (roughly half the range, or better, of an average trading day for that stock).
3. An above average degree of trading volume taking place on the current day.

When these three components all exist in a two-day price pattern, it is usually referred to as an exhaustion gap and technical analysts expect that this signal implies prices will trend lower over the days and weeks ahead. The following chart is an example of an exhaustion gap that occurred on Netflix shares in the summer of 2018.

Image by Sabrina Jiang © Investopedia 2021

Notice how the price action shown in this chart is trending higher prior to the exhaustion gap, and the gap and following price drop appear to break the most recent trend. In the first example noted, the price reaches a climactic peak and the volume surges higher, culminating in the highest volume on the day following the downward, exhaustion gap. Buyers had previously been enthusiastically buying shares sending the price rapidly higher. Whatever was driving these buyers to purchase the stock at these prices was drawing the attention of many potential investors. Once the price reached its highest level, then it was as if there were simply no more buyers to push prices higher.

The gap day shows that sellers aggressively entered the market and seemed more concerned with getting out at all costs rather than preserving a good price for the stock. Thus, the day after, the gap opens higher and closes lower, leaving a large red-colored candle, depicting a tremendous amount of selling that day. The second example circled on the chart does not occur directly after the peak in prices, but it clearly violates the trend line and sets the stage for significant price drops thereafter.

Since securities do not continue in a trending direction infinitely, at some point they will typically see price momentum slowing. When price momentum slows, an exhaustion gap is likely to occur. Exhaustion gaps signify that the last push in a direction before the security shows a reversal. Exhaustion gaps can be difficult to identify and may be easily confused with runaway gaps.

Part of the confusion behind this stems from the fact that some authors have described the exhaustion gap as a gap higher in price that occurs at the end of an upward trend, but there are two problems with this definition. First, this definition makes the gap indistinguishable from other, more common gap signals such as a runaway gap. Second, this definition means that the signal can only be classified as an exhaustion gap in hindsight after the trend fails, rendering it useless for forecasting.

The definition provided in this article favors a more useful signal for forecasting trend reversals. Exhaustion gaps typically occur as the beginning of a trend reversal as evidenced by the way the price action after the gap will often violate a previous trend line. This moment in time, where price breaks a former trend, creates a substantial market opportunity for traders who want to be participating in the early stages of a new trend.