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.
An exhaustion gap can be one of the first signs that the established trend is coming to an end. The price tends to subsequently move in the same direction as the exhaustion gap for a short period before moving sharply in the opposite direction as a new trend begins.
For instance, when an exhaustion gap occurs at the tail end of a bullish trend, investors tend to be scrambling for the asset in a final wave of euphoria. However, this is shortly followed by a period of intense profit taking and waning demand for the asset that marks the beginning of a new trend to the downside.
Trading an exhaustion gap
As an example, suppose we are tracking the share price of oil services company Schlumberger. The stock has been in an established uptrend over the past few months and weeks.
We see the stock close at $67.5 on Friday but open at $70 on Monday on trading volumes more than twice the average, a typical sign of an exhaustion gap.
The stock closes at $73 at the end of Monday, but on Tuesday we see the stock fall sharply, back to $68, with volumes nearly three times higher than average, indicating very strong selling pressure. As we seek to take advantage of the new downtrend, we initiate a sell order at $67.5, the level from which the stock originally gapped up.
We use the distance from the beginning of the price gap to the peak reached on the final frenzied buying phase to set a profit target. We therefore set a profit target of $5.5 ($73− $67.5) and exit the trade on Wednesday, when the stock is at $62, extremely pleased with our trade.
We implemented a stop-loss order for the trade at $68.5, modestly above our entry point. Had we been prepared to hold the short position for longer, we could have made additional profits as the stock continues to fall over the subsequent trading sessions, with the next price trough coming about two weeks later, at $53.