Option Investor
Trader's Corner

Exhaustion Gaps

Printer friendly version

Gaps, gaps, and now more gaps: the last couple of Trader's Corner articles have discussed a couple of types of gaps. When more than a couple appears on a chart, however, you may be seeing exhaustion gaps.

Annotated Daily Chart of CME:

In TECHNICAL ANALYSIS EXPLAINED, Martin J. Pring warns that "the presence of a second or third [runaway] gap should . . . alert the technician to the fact that the move is likely to run out of steam soon." Pring cautions traders who have too much risk on the table that an exhaustion gap might be a warning that they should lower that risk.

Pring offers clues to the presence of an exhaustion gap, but not all those clues were present on CME's chart. Pring says that prices will often move back toward the gap (down if prices gapped up and up if prices gapped down) by the end of the day. In addition, exhaustion gaps are often accompanied by large volume when compared to the price movement.

Volume was large the day of the gap, but CME's price movement was also large. Obviously, prices also closed near their high and not near the gap.

However, that information about identifying exhaustion gaps piqued my interest because of my study of Tom Williams' volume/price-spread analysis. In MASTER THE MARKETS, Williams warns that market tops are often accompanied by high-volume days. He says if the markets have been rallying and high volume suddenly appears but is accompanied by prices that close nearer the low of the day than the high of the day, you must consider the negative result (price action) of all that effort (volume). "[A] wide spread up-bar, closing on the lows, on increased volume, is bearish, and represents effort to go down" when coming after a rally. Although this section of his book does not specifically address gaps, the chart he supplied to illustrate the point did include a gap and the information corroborated some of Pring's points.

Annotated Daily Chart of Computer Sciences:

Should one load up on options if an exhaustion gap occurs? It certainly seems so if that CSC chart is used as an example. However, CME's chart showed a different pattern: consolidation over several months, a sharp but short pullback just below the gap and then another charge higher.

Pring warns that an exhaustion gap "indicates only temporary exhaustion," not necessarily a sign of a major market turn. As has already been noted, both Pring and William mention price spread and volume patterns in connection with exhaustion gaps. Might it be possible to use volume/price-spread patterns to distinguish between an exhaustion gap that signals a potential market turn and one that signals consolidation?

That's an intriguing thought. It's especially intriguing when one considers that CSC's exhaustion gap met William's volume/price spread conditions for a possible market top and was in fact topping while CME did not meet Williams' parameters. It did meet some but not all of Pring's for an exhaustion gap.

With the warning that anything examined in this article will be anecdotal evidence only, let's look at other charts, seeing what we find.

Annotated Daily Chart of PCLN:

Some might even argue that PCLN's action after the third gap was a continuation of the rally since PCLN climbed another hefty percentage, but the head-and-shoulders formation contributes to a different interpretation. Our point, though, is to decide whether anything on the chart might have foretold that this third gap, a candidate as an exhaustion gap, was not signaling an immediate market turn?

Did this chart show characteristics that met Pring's parameters for an exhaustion top? It did meet some. The gap was the third in that particular rally. The volume was high relative to previous days and weeks. Prices, however, did not drop back toward the gap by the close, and the spread or price range was relatively wide that day, so not all parameters were met.

This meant that the candle produced the day of the gap would not have met the most important of Williams' parameters for a market top. Williams looks for signs of weakness when prices are climbing. Volume much bigger than previous days' volume signals to him that there was some institutional involvement in the action, so he would have urged traders to pay particular attention to the price spread that day as well as to where the prices closed that day. What was the result of all that effort that the higher volume signified?

In this case, prices pulled back only slightly from the day's high, and in fact closed rather near that day's high. The day's range was wide. All that effort in fact produced a lot of results, verified when Priceline's stock climbed again the next day. When looking at effort (volume) versus results (price action), we don't see anything on that candle to lead us to the impression that big money was using that day to distribute stock. It didn't look like a market top, at least from that evidence alone.

If I'd been combining what Pring has to say about identifying exhaustion gaps with what Williams has to say about identifying market tops, I would have had to have voted in the "probably consolidation will follow" camp. Of course, that's easy enough to say in hindsight, isn't it?

So, let's test the idea by finding a stock that looks as if it might be meeting both Pring's parameters for an exhaustion gap and William's for a potential market top or bottom. If both sets of conditions are met, we might conclude that a trend reversal, at least over the short-term, would look more probable than mere consolidation.

Since the chart I located showed a possible exhaustion gap at the bottom of a steep decline, it's important to consider what signs Williams looks for at a market bottom. The previous discussion involved market tops. When looking for a market bottom, Williams also searches for signs of institutional involvement (high volume relative to previous days) and then looks at the result of that involvement. While some would consider any large volume on a decline as validation of the bearishness, Williams cautions that traders should be more attentive.

If the volume signaled that big money was involved, what was big money doing? What was the result of their effort? Did prices bounce by the end of the day? If so, wasn't big money likely accumulating?

Annotated Daily Chart of ARRS:

Note: When I scroll back on a chart, my charting program outlines the scroll bar in red, as it did with CME's chart, the first shown in this article. You can check then, that I didn't just roll back a chart so I could make it fit the discussion about what it predicts. This chart was snapped after the close February 15, my annotations made then, and the scroll bar shows that.

Large volume was present, a sign of big-money involvement according to Williams. Big money must have been accumulating, Williams might have concluded, although he certainly would have warned that big-money accumulation doesn't promise that prices will always and immediately go higher. If they'd been doing all the dumping and little of the buying, it would have been nearly impossible for mom-and-pop retail trader to absorb that heavy volume and send prices that far off the low by the end of the day.

As of February 15, then, it looked possible that an exhaustion gap was forming that might signal at least a short-term turning point for ARRS. Williams cautions in his book that even when we see signs of accumulation, a turnaround might not be immediate. Big or smart money can afford to begin accumulating while a stock is still going down if they think a turn may be approaching. Mom-and-pop retail trader can't always afford to do that. He offers suggestions about retests, for example.

Perhaps the combination of Pring's information and Williams' conditions points to a turning point in ARRS. Perhaps not. Three or four charts don't prove a theory, as intriguing as the information they contain might be.

Whether AARS bounces or not, the chart's picture is not a pretty one, and that gap's upper boundary may serve as strong resistance, so this was not meant as a trade suggestion. As I edit this article midmorning on February 22 in preparation for submitting it, ARRS trades at $5.97, an 8.5 percent gain from the value shown on that chart. The candles produced over the last few days have been small-bodied candles rising like wisps of smoke on lower volume, so it's been consolidating sideways up. It's possible that prices may need to come back and retest, so again, I'm not offering this as a trade suggestion, but only as an illustration of what you might look at with an exhaustion gap.

However, bearish traders have been forewarned by the presence of the possible exhaustion gap to consider lightening up on positions and to plan for a possible bounce.

That's what an exhaustion gap does: it warns traders that a trend may be changing. A prolonged consolidation or even a trend reversal may be at hand. While price action should guide the choices that are made from that point, the presence of a third or fourth gap alerts traders to make a plan. Those who are too highly leveraged in a trend-related move can plan how they'll hedge or reduce their risks. Perhaps you'll decide that Pring's and Williams' information helps you differentiate those times when exhaustion gaps are likely to be followed by consolidation from those when it signals a reversal, but that's something to be discovered only after much experimentation.

Trader's Corner Archives