Exhaustion Gap Trading Strategy For Reversals

Imagine waking up to find that your favorite stock has gapped up overnight and given you a windfall profit. Is it time to grab your profits and go? Is it time to reverse your bias and sell short the stock?

If the gap is an exhaustion gap, then the answer is probably yes.

An exhaustion gap is found after a trend is exhausted. In a bull trend, an exhaustion gap is an up gap that represents the last climatic buying. The gap represents a surge of ultra-late buyers. Having no more fools to buy after them, the trend is ready for reversal. Hence, the exhaustion gap trading strategy is a trend reversal play.

(Read: 4 Types of Trading Strategies)

Rules For Exhaustion Gap Trading Strategy

An exhaustion gap occurs with extremely high volume. I have a standard method for finding extremes using Bollinger Bands. In this case, we want to find extreme volumes, so I applied a 233-period Bollinger Band with 3 standard deviations using the volume bars. Any volume bar that exceeds the upper Bollinger Band is extreme.

Bullish Reversal

1. A bear trend
2. A down gap with extreme volume (as we defined above)
3. Gap closed within five bars

Bearish Reversal

1. A bull trend
2. An up gap with extreme volume (as we defined above)
3. Gap closed within five bars

Exhaustion Gap Trading Strategy Examples

Winning Trade – Bullish Reversal

This is a daily chart of C. R. Bard, Inc (BCR). The lower panel shows the volume. The orange line is the upper line of a Bollinger Band (233,3) for finding extreme volumes.

1. There was a clear bear trend. You can define the market trend using your own trading methods. But generally, the longer the trend, the more likely a reversal trade will succeed.
2. This down gap made a new low with extreme volume. The bullish bar that followed the gap showed strong bullish pressure. Price closed the gap within 3 days and we bought as soon as price closed the gap.
3.  A triangle developed after our entry. Using the triangle measuring rule gave us a good first target. (dotted arrows)

While this exhaustion gap caught the market low, the timing was not great as price meandered sideways after our entry. However, BCR did not make a new lower low after the gap, which confirmed that the gap was exhaustive.

Losing Trade – Bullish Reversal

This is the daily chart of Zions Bancorporation (ZION). It shows a gap that was not exactly exhaustive.

1. Every reversal trade needs a trend to reverse. In this case, we had a bear trend.
2. This down gap looked like an exhaustive gap with extreme volume. ZION filled the gap on the fifth day, which makes it less impressive than the BCR trade which filled it on the third day. For exhaustion gaps, the sooner it is filled, the more likely we have a reversal.
3. Instead of reversing the trend, price fell and made a new low, stopping out all reversal traders.

While this trade failed technically, it is somewhat exhaustive as it halted the down trend. No analysis is perfect. In this case, we might have mistaken a common gap for an exhaustive gap.

Review – Exhaustion Gap Trading Strategy

There are four types of gaps including common, breakaway, runaway, and exhaustion. The exhaustion gap is distinctive because it gaps further with higher volume. It is easier to label an exhaustion gap. Hence, it is a great basis for trading a reversal.

However, in the exhaustion gap trading strategy, the safe stop-loss level is the extreme low of the trend for bullish reversal. (Reverse for bearish reversal.) Placing a tighter stop will expose us to whipsaws which are common after price fills the gap.

If you are uncomfortable with large stops, wait for bullish chart formations or bar patterns before entering. These entries will offer a tighter stop-loss. (Like the triangle formation in the winning example.) However, you will miss some of the best reversals that take off without looking back.

High volume is a sign of trend exhaustion even without gaps. Look out for bars with abnormally wide range bars with high volume. If they have no follow-through, you might have a reversal trading setup.

Take a look at these two books for more gap trading ideas:

• Technical Analysis of Gaps: Identifying Profitable Gaps for Trading
• Stock Gap Trading Strategies That Work (Connors Research Trading Strategy Series)