Runaway and exhaustion price gaps are often confused with one another, though being able to correctly differentiate between them can potentially lead to much more profitable trades.
Runaway gaps occur as part of an existing trend, as more traders take positions in line with the direction of travel. Such gaps can be thought of as resulting from increased interest in the asset, manifested by rising momentum.
Runaway gaps to the upside often occur because traders who missed out on the earlier uptrend have suddenly joined the party. These gaps could also be associated with positive news flow that is creating new interest from traders.
On the downside, it can be indicative of new sellers joining an existing downtrend, or negative news flow causing both new shorters and existing holders to liquidate their holdings. Such a runaway gap to the downside may therefore occur because there are suddenly no buyers at a given price level.
In either scenario, whether we are dealing with an upside or downside runaway gap, they should be characterised by increased volume, both during and after the gap is created.
Trading a runaway gap
As an example, suppose we are tracking Twitter’s stock price. The stock closes at $28.9 on Friday but opens at $29.7 on Monday. As we detect increased trading volume we decide to implement a buy order on Twitter at $29.8.
The price gap is in the same direction of travel of the upward price trend that we have viewed over the recent days, weeks and months. We adopt a much more cautious strategy than we would if this were the beginning of a new trend.
The stock continues to move higher during the trading day and we close out the position towards the end of the day at $31.4. Our $1.6 profit per share on the trade is twice the distance of the price gap we observed ($29.7− $28.9 = $0.8).
Exhaustion gaps tend to occur towards the end of a bullish or bearish phase, though in the same direction as the existing trend. They are characterised by much higher volume than runaway gaps.