DEFINITION of 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. 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.
BREAKING DOWN Exhaustion
When a person is exhausted, he is too tired to continue. For example, an athlete may hit a wall of exhaustion from muscle fatigue. When this happens, the athlete must stop. 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.
Exhaustion at the Auction
At an auction, there are bidders and sellers. The former are bidding on an asset or security to buy it, and the latter are offering a price for buyers. When there are more buyers than sellers in the room, the price goes up. Likewise, when there are more sellers in the room, the price goes down.
A trade 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 up or down. When this happens, traders can expect a trend reversal. Suddenly, buyers seats are filling up with sellers, or vice versa. These trend reversals help traders select entry and exit points in the market.
Traders can identify periods of exhaustion by looking at the Commitments of Traders Report. This report is published every week and shows levels of open interest 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 buy these assets back at a higher price.
Another way traders can identify periods of exhaustion is by looking at momentum and relative strength indicators. Momentum indicators provide traders with a trend line. When that trend line is over the average, it means the stock or asset could be oversold or overbought. When the trend line goes above or below an average, it means traders may be getting exhausted and a reversal is imminent.