Exhaustion Gaps
When trading jumps above a previous day high at the opening to make new
highs while leaving a blank in a chart this is called a gap.
Gaps appear most frequently in daily charts, where every day is a new
opportunity to trade higher or lower than the previous days high or low. We
can also use them in our 60-minute charts and they can signal a change in
direction much quicker than a daily chart.
Gaps can provide a clue to an important change in the fundamentals of a
particular stock or the crowd psychology accompanying the general market
has changed dramatically. This could be because of a change in interest
rates, earnings or other critical information that traders and investors
have about the future of the stock and economy.
Although most of my work and trading is with the trend, the presentation of
various patterns and indicators is the purpose of this column.
Gaps come in different forms and different situations. Some are useful in
interpretation, while others are just random behavior and do not work as
expected.
An exhaustion gap is a last gasp in a trend that is about to end.
Typically, the exhaustion gap occurs on the last or next-to-last day of a
quickly moving price trend with very high volume. The day will start off on
extremely bullish news (for a bull market), and players usually have
reached a feverish attitude about trying to be involved. The latecomers pay
up to join the crowd when a wave of profit taking hits the market. This
selling overwhelms the players because the demand for the stock has been
"exhausted." There simply is no bid. Offers to sell will continue to enter
the market as participants recognize that the current price has overvalued
the stock.
It is not easy to distinguish an exhaustion gap from a runaway gap except
for the volume and following day action. I therefore highly recommend
anyone that trades these gaps to use close stops. These can usually be
placed above the previous day or two high for the stock. If it is truly a
reversal, the stock will not return the high reached in the exhaustion move
and in most cases close near the day’s low.
Let's look at Sun Microsystems (NASDAQ: SUNW).
SUNW has been a market leader, particularly over the past couple of weeks.
On October 28, 1999 SUNW broke a high of 95 and ran quickly to new highs.
Today, November 2, 1999, SUNW opened up and quick ran up over 6 points on
huge volume.
However, by the end of the day, trader's remorse and/or profit taking took
over in the stock.
SUNW actually closed down on the day after being up 6 points.
This pattern can be an exhaustion gap formation which is a negative
reversal pattern.
I would exit longs in SUNW.
An aggressive short term trader may want to establish a Short position here.
I would place on a short at 106 �.
When this pattern works out, the stock usually will continue straight down,
so a tight stop can be used.
