What Is Exhaustion?
Exhaustion is a situation in which a majority of participants trading in the same asset are either long or short, leaving 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 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.
Exhaustion implies a state or condition that is difficult to fight, and 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.
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.
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.
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.