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 to which 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 regularly on small and large scales.
  • 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.
  • 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.

Understanding Exhaustion

When a person is exhausted, they are too tired to continue. For example, an athlete may hit a wall of exhaustion from muscle fatigue. When this happens, the athlete has a hard time continuing to train. 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 it, and the latter are 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 up or down respectively.

When this happens, traders can expect a trend reversal. Suddenly, buyers seats are filling up with sellers, or vice versa.

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, 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 it exhausted itself 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.

exhaustion reversal chart example in NVDA
 TradingView

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 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, as typically volume help confirm price moves, as in rising prices are accompanied by rising volume on the moves up.

Excessive volume can also indicate an impending reversal, as the massive volume spike typically means everyone who wanted in got in. This scenario is more common in blow-off tops. The Nvidia case was a 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.