An exhaustion gap is a critical concept to understand when trading stocks at the market open. A gap refers to a stock that opens above or below its prior closing price. An exhaustion gap is different from most gap ups or gap downs in that it quickly reverses from the direction the stocked gapped in.
It is characterized by a strong counter-trend move in the opposite direction a stock has been trending in for prior days/weeks. There are two types of exhaustion gaps: Bearish exhaustion gaps, and bullish gaps. Here are examples of both:
Bullish Exhaustion Gap Example
A bullish exhaustion gap occurs at the end of a strong downtrend in a stock. Here is a bullish exhaustion gap example with Kroger stock:
Notice how it has a huge red day right before the circled green candle. And then the stock gapped down, even more, the next day. At this point, all of the supply has dried up since the stock has dropped so much in a short period of time (in this case it was bad earnings) and it was due for a dead cat bounce. As soon the market opened the gap was bought up and the stock rallied strongly.
Bearish Example
A bearish exhaustion gap is the opposite of a bullish one. It is a stock that gaps up which is sold into strongly. Here is an example of a bearish gap in Nvidia stock:
You can see how it had a strong run-up, and then a huge green day the day before it had that huge sell-off into the exhaustion gap. It gapped up even further after a big day, and there was a scramble for traders and investors to take profits soon after the market opened.
Anticipating Exhaustion Gaps
You are probably thinking: How do I know the difference between an exhaustion gap or a gap that is just a trend continuation? How you can identify a likely exhaustion gap candidate is a stock that starts to reverse trend soon after the market opens after a big gap up in a strong uptrend or a big gap down in a strong downtrend.
As seen in the examples above, the exhaustion gap is the trigger for a short term trend reversal. Being able to recognize exhaustion gaps will allow you to take a position in a stock in anticipation of the gap reversing. These reversals will often be strong, as you can see in both examples, and can be great day trading opportunities if executed correctly.
Trading Exhaustion Gaps
This is a SHORT TERM trading setup. This is a trade you want to be holding for several hours, or maybe a couple of days. This is not a setup that you want to marry forever. NVDA resumed trend later that year and starting a run to the high $200’s. To make these high probability setups, you need to have EXTENSION in the names of interest. They have to be in an overbought or oversold state to make the setup trustworthy. This means you would to see an RSI above 80 for a short, or below 20 during the morning of the gap up.
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