How to trade using Exhaustion Gap Trading Strategy?

Today we are going to learn about Exhaustion Gap Trading Strategy

This price action step up is usually designed to trap you into a potentially weak market and into a poor trade, catching stop-losses on the long side, and generally panicking traders to do the wrong thing.

Different parts of Exhaustion Gap Trading Strategy

The Exhaustion gap means a gap formation at the end of an uptrend. Consider a stock is in uptrend for a long time and it is in the end of an uptrend, price gap ups.

When do you mean by end of uptrend? Simple – Price gaps up into/near a supply zone. This kind of gap is called Exhaustion gap. This is a sign of weak market. This type of gaps are created to trap traders.

There are four major parts which forms this pattern.

1.      Prior uptrend – The market was on uptrend for at least last 2-3 days. Market was already trending

2.      Gap up near or into supply zone – Price gaps up the next day near a supply zone or into a supply zone.

3.      Reversal candlestick pattern – Price struggles to move up after the gap up and continue to be range bound for a while. Price then forms Reversal candlestick pattern near the supply zone. This is the signal for price reversal to the downside.

4.      Closing the gap – When prices close under the gap, it gives the confirmation of the exhaustion gap. An exhaustion gap occurs with extremely high volume. 

Exhaustion gap generally occurs near the end of an uptrend. However, that upward gap quickly fades and prices turn lower. To put it simple, You will find that weak gap-ups are always the Gap up in to the resistance (i.e) gap up into supply zone. This is usually designed to trap retail traders into a potentially weak uptrend and into a poor trade, catching their stop-losses after they go long after looking at the gap up.

Importance of volume:

As I always say, the volume is most important thing you need to check for in any technical breakout pattern. This is applicable for gaps as well. It will be considered as double confirmation if the volume is thin when the price remains range bound and volume shoots up when the price forms reversal candlestick pattern. Also, when the price fills the gap and closes below the gap, it will have much more volume, this is a big confirmation as well.

Entry, Target and SL

You can enter into the trade once the price pullback forms Reversal candlestick pattern near the supply zone. New trades can wait, till the price breaks below previous day’s closing price and gives a pull back entry.

When it comes to this strategy, we should keep our SL slightly above the high of the day.

The target for this strategy is simple – use 2:1 as Risk reward ratio for this strategy, so if your SL is 10 points, your target will also be 20 points from your entry. But since this is reversal trade, your target can be big.

For more details and examples, checkout the video: