Trading exhaustion gaps is a successful trading technique that, if applied correctly and in the right market environment, can combine a high winning percentage with a high payout.
A gap in general is a jump in market prices between periods. One period opened at a significantly higher or lower price level than the close of the previous period. This is a significant event. Something made the market jump. In many cases, this jump could indicate a significant change in market sentiment that could lead to a new trend or accelerate the current trend.
These gap types are breakaway gaps and runaway gaps. They indicate a starting trend in the direction of the breakaway gap. Many traders, especially trend followers, specialize in recognizing and trading these gap types.
There is, however, another gap type that indicates the exact opposite of these gap types: The exhaustion gaps. An exhaustion gaps indicates a weakening trend or movement, and an impending reversal. A trader’s ability to recognize an exhaustion gap can save him from making bad investment decisions, and at the same time provide him with many good investment opportunities.
The exhaustion gap is the result of few traders pushing the market while the majority of traders are no longer willing to invest. This means, during the periods preceding the exhaustion gap, trading volume should be relatively low. An exhaustion gap indicates an impending turnaround. The current movement is likely over, and the market will reverse direction soon.
Often, exhaustion gaps are confirmed by a second gap in the opposite direction. This candlestick formation is called the island reversal, and is a very strong indication of a turnaround.
Depending on your strategy and which kind of option type you prefer there are a couple different ways to trade exhaustion gaps:
After an exhaustion gap, the market will turn around soon. Therefore, investing early will enable you to benefit from the impending movement the most. Being able to predict a long movement means you can trade the exhaustion gap with a touch option in the opposite direction of the gap. Touch options have the great advantage of providing significantly higher payouts than high / low options.
On the other hand, this strategy means you will be investing right after the gap. Therefore, you cannot wait for the market to confirm the gap by either starting the movement in the opposite direction or, ideally, by creating an island reversal. Therefore, you are likely to win a lower percentage of your investments. Since touch options offer four to five times higher payouts than high / low options, you should be easily to make up for that.
To make sure that you are dealing with an exhaustion gap and that the market will indeed turn around, you can wait for a few periods. The market should either turn around or create a gap in the opposite direction of the exhaustion gap. This would complete the candlestick formation island reversal, a very strong indication of a turning market.
Since the waiting period will likely caused you to miss a part of the movement, you should consider investing in touch options carefully. There is a good chance you will generate higher profits with high / low options.
Exhaustion gaps occur during periods with low trading volume. If you are planning to invest in exhaustion gaps, you can therefore predetermine when exhaustion gaps are likely to occur.
Low trading volume occurs mostly during the late trading hours. In these periods, day traders, which create a big part of the daily volume, have finished trading for that day. Additionally, traders start to take the profits they made during the day to avoid having their earnings wiped out by an unforeseen event over night.
In summary, fewer traders are influencing market movements, and those traders in the market are likely to invest against the existing trend. This is the perfect setting for trading exhaustion gaps. As a trader specializing in exhaustion gaps, you should seek these market environments to find the best trading opportunities.
Any regular trader should be aware that a gap is more likely than an exhaustion gap during these trading periods and adapt his trading strategy accordingly. During the day, on the other hand, when many traders are in the market and trading volume is high, trading exhaustion gaps are relatively rare. In these periods you should expect mostly breakaway gaps and runaway gaps.