Exhaustion: Definition, Indicators, Stock Trading Example

What Is Exhaustion?

Exhaustion is a situation in which a majority of participants trading in the same asset are either long or short, which leaves few investors to take the other side of the transaction when participants wish to close their positions. For example, if everyone has already bought, when those people want to sell, there will be no more buyers to sell. This will cause the price to fall.

Exhaustion often signals the reversal of a current trend because it illustrates excess levels of supply or demand, indicating a market is either overbought or oversold.

Key Takeaways

  • Exhaustion occurs when most everyone who wants to be long or short already is, leaving very few people to support or continue pushing the price in the current direction.
  • This can occur regularly, both on small and large scales.
  • Exhaustion can potentially be identified by looking at the number of participants who are long or short, watching for blow-off tops, or looking for reversals based on swing highs and lows.
  • An exhaustion gap occurs when there is a sharp downward break after prolonged price rises, or an upward break after price losses.
  • In the most extreme examples, a blow-off top can turn sharp price gains into significant losses.

Understanding Exhaustion

Exhaustion implies a state or condition that is difficult to fight: Surrender to the inevitable is imminent. The same goes for exhaustion in the financial markets, which is based on auctions.

At an auction, there are bidders and sellers. The former are bidding on an asset or security to buy, and the latter is offering a price for buyers. When there are more aggressive buyers than sellers, the price goes up. Likewise, when there are more aggressive sellers, the price goes down.

A trend is exhausted when the price of the asset or security has moved too far in one direction. This may occur when the number of buyers in the auction dwindles and sellers start to take over. Exhaustion is reached when the asset or security does not have the support from buyers or sellers to continue moving either up or down.

When exhaustion happens, traders can expect a trend reversal.

Identifying Exhaustion

Traders can identify periods of exhaustion by looking at the Commitments of Traders Report. This report is published every week and shows position levels in the futures markets.

An excessively high number of long contracts could indicate that everybody who wishes to be long has already taken a position, leaving few investors to keep buying the asset at current prices (let alone higher prices). If there is likely no one left to buy, then sellers will start becoming more aggressive to get out of long positions or get short.

Blow-off tops are an extreme example of exhaustion. The price has been rising aggressively on increasing volume. But, eventually, the sellers overwhelm the buyers, the buyers turn into sellers, and the price falls dramatically.

Exhaustion on a small scale occurs on every price wave. The price moves up or down—and then has a pullback. It occurs on one-minute charts with small trend reversals and pullbacks, and it occurs on longer-term weekly and monthly charts in regards to large trends.

Technical traders view uptrends as a series of rising swing lows and swing highs. Lower swing lows and lower swing highs indicate the uptrend could be in trouble and a reversal may be underway. A downtrend is a series of lower swing lows and lower swing highs. Higher swing lows and higher swing highs could indicate a reversal to the upside.

Exhaustion cannot be identified by simply looking at a price chart. Traders look to other metrics, such as volume and the Relative Strength Index, to confirm whether a market is over- or under-sold.

Example of Exhaustion in a Rising Stock

The following chart shows that Nvidia Corp. (NVDA) was in a prolonged uptrend before the stock was exhausted and reversed to a significant degree.

During the rise, the price was making overall higher highs and higher lows and, in this case, respecting a rising trendline.

Image by Sabrina Jiang © Investopedia 2021

The price then drops below the trendline and also made a lower swing low, followed by a lower swing high. The reversal has started and the price continues to drop as sellers overwhelm any buyers that are remaining.

Volume dropped through much of the rise, showing that there was less and less interest at the higher and higher prices. This was a warning sign of upcoming exhaustion; typically, volume help confirm price moves—rising prices are accompanied by rising volume on the moves up.

Excessive volume can also indicate an impending reversal because the massive volume spike typically means everyone who wanted to buy was able to buy. This scenario is more common in blow-off tops. The Nvidia case was not a blow-off top, rather it was a steady uptrend that progressively had less interest. When sellers started to become more aggressive, there were not enough buyers to support the price, even as the price got cheaper and cheaper.

What Is Trade Exhaustion?

In the financial markets, exhaustion is a situation where the majority of traders trade in the same side of the transaction (either short or long) and the same asset. As a result, there are only a few traders on the other side of the transaction.

What Is the Opposite of Exhaustion?

If exhaustion is a market that is strongly tilted towards buyers or sellers, the opposite circumstance could be described as sideways drift. This is when the price of a security or other asset continues to trade between support and resistance levels, without any strong breakout movements in either direction. In most cases, the market is approximately evenly balanced between long and short players, with sell and buy pressures approximately equal.

What Is the Downside of Day Trading?

Day trading is the practice of attempting to profit from short-term swings rather than long-term trends. It tends to be unprofitable in the long run, due to both the difficulty of predicting market movements and the accumulating costs of trading.

On average, even the best stock pickers tend to underperform the market, and even a marginally-profitable day trader would lose much of their profits to broker fees and commissions. For that reason, most experts advise long-term acquisitions over short-term day trading.

How Do You Trade Exhaustion Gaps?

An exhaustion gap is a downward break after a long period of price gains, or an upward break after a long sell-off. This is usually considered a sign of a trend reversal, although this signal is sometimes only easy to identify in hindsight. Since exhaustion gaps indicate the beginning of a trend reversal, a confident trader would purchase the asset if they believed the market was oversold, and sell or short the asset if it were overbought.