Panic selling occurs when a stock price rapidly declines on high volume. This often happens when some event forces investors to re-evaluate the stock's intrinsic value, or when short-term traders are able to force the stock price down far enough to trigger long-term stop-losses. The entire process creates a tremendous opportunity for bottom-fishers to initiate long positions, especially if the event behind the panic selling was non-material or speculative in nature (such as a SEC investigation or an analyst opinion). Here, we shed light on the panic-selling process and introduce a model that can help you predict the right time to take a long position after panic selling occurs.

The Process
Panic selling happens in several phases. Figure 1 illustrates a typical panic selling scenario that occurred as a result of a SEC investigation. The company in this example is Doral Financial (NYSE:DRL), a corporation whose primary business is mortgage banking, but this chart can be read as a general illustration of what happens in panic selling situations.

Figure 1
Source: Tradecision

Let's break down what happens at each numbered step in the chart:

Step 1 - Something occurs that causes the stock price to rapidly decline on high volume.

Step 2 - Eventually, a high volume day occurs when buyers and sellers fight for control of the trend. The winner then takes the trend on low follow-up volume.

Step 3 - If no significant trend change occurs at point 2 (i.e., a continuation), then there is typically another point of high volume in which a substantial reversal (long or short term) may occur.

Step 4 - This process continues until a long-term trend is established and confirmed with technical or fundamental factors.

Now we'll look at how we can predict when a trend change is going to occur.

The Exhausted Selling Model
The exhausted selling model (ESM) was developed to determine when a price floor has been reached. This is done by using a combination of the following trend, volume and turnaround indicators:

Figure 2 illustrates how this model works.

Figure 2: Exhausted selling model

Notice that a variety of indicators are used to confirm that the trend has changed. As a trader, you may choose how many confirmation indicators you wish to use. The fewer confirmation indicators used, the higher the risk and the higher the reward (in the sense that, the longer you wait for confirmation, the less potential gain there will be for you to capture), and vice versa.

The rules to using the ESM are as follows:

  1. The stock price must first rapidly decline on high volume.
  2. A volume spike will occur, creating a new low, and appear to reverse the trend. Look for candlestick patterns showing a struggle between buyers and sellers here (i.e., cross patterns or engulfings).
  3. A higher low wave must occur.
  4. A break of the predominant downward trendline must occur.
  5. The 40 and/or 50-day moving averages must be broken.
  6. The 40 and/or 50-day moving average must then be retested and hold.

Note that you may use other moving averages - ideally, ones that connect highs or lows. Typically, a break of a larger moving average is more indicative of a trend break than smaller moving averages.

As you can see, the ESM combines several techniques to ensure that the trend has changed for the long term.


Now let's take a look at Figure 3, which will show the ESM in practice

Chicago Bridge & Iron (NYSE:CBI) announced that its earnings would be delayed, which sent the stock down 16% in a matter of hours. First, we can see that the low was made on high volume just before 11:26 a.m. Next, the price moves up slightly, but eventually forms a descending triangle, from which we drew a trendline (indicated here by the red line). Next, the price breaks through the trendline and moving averages (indicated by the green dot on the left). It then retraces to the moving averages (shown by the green dot on the right) before moving upwards.

Figure 3

Finally, we can see that CBI turns around and returns to its previous levels after all of the confirmations are present. Note that if you would have entered after just one or two of the indicators, you would have made more profit, but increased the risk of the trade.

The Bottom Line
Panic selling naturally creates great buying opportunities for well-informed traders and investors. Those who know when the selling is over can benefit from the retracements/turnaround that often occur afterwards. The exhausted selling model explained here provides a safe and effective method to determine where the best entry point is, and the ESM's use of multiple indicators can help you avoid costly mistakes.

SEE: Volatility Index Uncovers Market Bottoms, and check out Market Problems? Blame Investors and How The Power Of The Masses Drives The Market.

Related Articles
  1. Active Trading Fundamentals

    Simple Moving Averages Make Trends Stand Out

    The moving average is easy to calculate and, once plotted on a chart, is a powerful visual trend-spotting tool.
  2. Trading Strategies

    Risk Management Techniques For Active Traders

    Use stop-loss and take-profit points to your advantage with these strategies.
  3. Active Trading Fundamentals

    The Utility Of Trendlines

    Trendlines give an investor a good idea of the direction an investment might move in. Discover how to make them work for your portfolio.
  4. Options & Futures

    The Importance Of Time Value In Options Trading

    Move beyond simply buying calls and puts, and learn how to turn time-value decay into potential profits.
  5. Active Trading

    Manipulating Facts to Fit a Theory: A Dangerous Trading Practice

    This practice is common with experienced and new traders, and it can lead to huge losses. Find out how to avoid it.
  6. Trading Strategies

    Simple Strategies For Capitalizing On Trends

    Find out how following a trendline bounce or a new swing high or low can help you get into a trend early.
  7. Economics

    What Caused The Great Depression?

    Learn how government actions may have contributed to this major economic downturn.
  8. Active Trading

    Do Adaptive Moving Averages Lead To Better Results?

    These complex indicators can help traders interpret trend changes, but are they too good to be true?
  9. Investing

    2 Common Ways to Misuse Target Date Funds

    The world of asset classes is just as complicated as taking vitamins. How much should you take of small caps? Intermediate bonds? Emerging market stocks?
  10. Technical Indicators

    Explaining Autocorrelation

    Autocorrelation is the measure of an internal correlation with a given time series.
  1. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  2. How are Exhaustion Gap patterns interpreted by analysts and traders?

    Exhaustion gaps are one of the four major gap patterns that appear in price charts (the others being common, breakaway and ... Read Full Answer >>
  3. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  4. Are mutual funds considered retirement accounts?

    Unlike a 401(k) or Individual Retirement Account (IRA), mutual funds are not classified as retirement accounts. Employers ... Read Full Answer >>
  5. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  6. Do penny stocks pay dividends?

    Because of the small market capitalization and revenues typical of most penny stocks, there are very few that offer dividends. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  2. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  3. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  4. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  5. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  6. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!