An exhaustion gap is a gap that occurs after a rapid rise in a stock's price begins to tail off. An exhaustion gap reflects slowing momentum usually from falling demand for a stock.
An exhaustion gap is one of many gaps that can occur in trading. Technical analysts identify various types of gaps at different phases of trading.
Trading gaps occur when a security shows a large change from one quoted price to the next quoted price. On a technical chart, a trader would see a large gap in the charted price series. Generally, securities will follow a trend with incremental price action moving sideways, higher or lower. A gap in trading will typically be the result of a specific market event which has changed the outlook on the price either positively or negatively. (See also: Analyzing Chart Patterns: Gaps)
When trending higher or lower, securities will typically follow a trading cycle which can include a breakaway gap, followed by a runaway gap and then an exhaustion gap. A breakaway gap occurs when a price changes significantly in a particular direction. As a stock gains momentum in that direction it may see increased support from other traders seeing similar market sentiment. If momentum continues to build the stock is likely to show a runaway gap (also known as a continuation gap). A runaway gap occurs when a price is trending in a specific direction and then sees a significant gap to support the trend. A security can report multiple runaway gaps.
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 the last push in a direction before the security shows a reversal. Exhaustions gaps can be difficult to identify and may be easily confused with runaway gaps. (See also: What are the main differences between a Runaway Gap and a Exhaustion Gap?)
Interpreting the difference between a runaway gap and an exhaustion gap can be a key inference for new trading opportunities. Exhaustion gaps typically occur before reversals which creates a substantial market opportunity.
Assume for example that a security’s price had a breakaway gap resulting in a bullish trend. The stock price has moved higher with several runaway gaps reported. A trader believes that it is reaching its peak and could watch for an exhaustion gap as a sign to begin selling in order to gain some profits from the reversal.