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.
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.
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:
- The stock price must first rapidly decline on high volume.
- 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).
- A higher low wave must occur.
- A break of the predominant downward trendline must occur.
- The 40 and/or 50-day moving averages must be broken.
- 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.
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.
Active Trading FundamentalsThe moving average is easy to calculate and, once plotted on a chart, is a powerful visual trend-spotting tool.
Trading StrategiesUse stop-loss and take-profit points to your advantage with these strategies.
Active Trading FundamentalsTrendlines give an investor a good idea of the direction an investment might move in. Discover how to make them work for your portfolio.
Options & FuturesMove beyond simply buying calls and puts, and learn how to turn time-value decay into potential profits.
Active TradingThis practice is common with experienced and new traders, and it can lead to huge losses. Find out how to avoid it.
Trading StrategiesFind out how following a trendline bounce or a new swing high or low can help you get into a trend early.
Active TradingThese complex indicators can help traders interpret trend changes, but are they too good to be true?
EconomicsLearn how government actions may have contributed to this major economic downturn.
Chart AdvisorEuropean companies, listed on US exchanges, that are providing buying opportunities right now.
Chart AdvisorWeekly technical summary of the major U.S. indexes.
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 >>
Exhaustion gaps are one of the four major gap patterns that appear in price charts (the others being common, breakaway and ... Read Full Answer >>
The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
Unlike a 401(k) or Individual Retirement Account (IRA), mutual funds are not classified as retirement accounts. Employers ... Read Full Answer >>
Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
Because of the small market capitalization and revenues typical of most penny stocks, there are very few that offer dividends. ... Read Full Answer >>