How To Screen And Trade Exhaustion Gaps
Hello, and welcome to the profitable world of technical analysis of stocks
. This article will examine price gaps in stock charts, and will dive into the cause of exhaustion gaps, a specific type of price movement that indicates an impending bearish reversal.
What Is a Gap?
For those of you who are unfamiliar with price gaps in a stock chart, take a moment on your favorite search engine to do an image search for stock chart gaps. A gap is simply an area on a price chart that is devoid of trading. Typically, gaps occur between the close of the market the previous day, and the next day's open.
How and Why do Gaps Form?
There are many reasons a gap may form. From the fundamental traders stand point, a gap might form because of a positive earnings announcement, or an analyst upgrade of the stock, or sector in which the stock trades. Gaps occur when price moves during off market hours, or at the opening bell. This pent up demand would cause the bid / ask on the stock to rise, and thus cause the stock to open at a level higher than the previous days close.
What is an Exhaustion Gap?
Exhaustion gaps indicate the end of a well established trend. They are identified by massive spikes in volume and a significant gap in the direction of the prevailing trend.
The key in distinguishing an exhaustion gap from a run away gap (a trend continuation pattern) is the massive increase in volume. Exhaustion gaps typically occur on +200% volume or more!
Psychology of an Exhaustion Gap
During a bear trend, it is quite common to see traders liquidate positions during highly volatile corrections, or long term downward price moves. Institutional investors, institutional traders, and most professional traders have long since exited these markets, and the stock price is now being controlled by individual investors. A massive spike in volatility occurs until the stock price finds a support level.
Professional and institutional investors and traders quickly enter the market at these levels, quickly filling the gap, and reversing the price trend. This would be considered a bullish reversal.
In the other direction, a bearish reversal exhaustion gap is caused by bullish utopia. Every mom and pop begins entering the market, driving prices to unsustainable levels. The price gaps up with huge volume, then just as suddenly, profit taking causes volume to further increase, and eventually demand for the stock dries up. Novice traders who bought the stock later in the price spike quickly sell their position to avoid massive losses, causing a change in trend.
Copyright (c) 2009 Steve Warshaw
by: Steve Warshaw
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