What Is the Exhausted Selling Model?
The exhausted selling model is a technique used to estimate when a period of declining prices for a security has reached its end. It is employed by investors who seek to profit from a turnaround following a period of intense selling pressure.
- The exhausted selling model is a technique used by traders to determine whether a security has reached its price floor.
- It is commonly used when a security has come under intense "panic" selling.
- The exhausted selling model relies on price and technical information, such as recent trading volume, support, and candlestick or chart patterns.
Understanding the Exhausted Selling Model
The exhausted selling model is well suited for periods following unusually intense selling, otherwise known as "panic selling." In these situations, contrarian investors can profit by "buying the dips" at unusually low prices.
Panic selling can be described as the rapid sell-off of a security based on short-term events that are not clearly connected to the intrinsic value of that security. For example, a stock might face panic selling in response to a negative rumor from an ongoing legal battle. At times, panic selling can produce price declines that are far more severe than warranted by the news item that triggered the panic.
In these situations, the exhausted selling model can help contrarian investors to assess when the decline in price is likely to reach its lowest point. To accomplish this, it uses information regarding trading volume, moving average price history, and certain chart patterns to detect when a positive turnaround might be approaching. Because it is principally based on price chart information, the exhausted selling model is generally used by traders who follow the technical analysis approach to trading.
The exhausted selling model is similar to techniques used by value investors, who look for bargain opportunities by monitoring companies with low price-to-book (P/B) ratios, low price-to-earnings (P/E) ratios, and similar metrics. However, the exhausted selling model differs from these techniques because it is based only on the price history of the security rather than on its fundamentals.
Although different investors might use modified versions of the exhausted selling model, most versions involve the following guidelines:
- First, the security in question must have recently declined based on unusually high trading volume.
- Second, there must be recent evidence of buying pressure (following the decline), such as a bullish engulfing pattern or any type of bullish chart pattern within the price or in a technical indicator.
- Third, the stock tests a support area, such as an important moving average or a price where the security bounced off on prior declines, signaling a base of demand from buyers.
If all of these factors are in place, the exhausted selling model would predict that the stock has reached its low point in price and that a positive reversal will soon take place.
As indicated, these are general guidelines, and individual traders may trade variations of this model using technical tools of their preference.
Example of the Exhausted Selling Model
The following daily chart of ROKU Inc. (ROKU) shows a significant uptrend followed by a sharp, high-volume price decline.
A trader utilizing an exhausted selling approach would have noted the high volume and sharp selloff. They would have then looked for evidence of buying pressure, potentially near some support level.
In this case, the price declines into a support area based on a prior swing low. The price also dropped below the 100-day moving average—which some traders view as important—and then moved back above.
In terms of a bullish candlestick pattern or chart pattern, the price formed a small cup-and-handle pattern near support. The price broke out of the pattern to the upside, indicating a move higher. A few days prior to the cup-and-handle breakout, the stochastic oscillator made a bullish crossover in oversold territory.
A stop-loss order could be placed below the cup-and-handle (or below the swing low) once a trade has been entered. This helps control the risk in the event the price continues to decline.
Exhausted Selling Model vs. Catching a Falling Knife
The exhausted selling model is used to buy securities whose price has fallen but also exhibit positive technical characteristics of a bounce. This is distinct from catching a falling knife, a colloquial term for buying a sell-off without studying technical indicators. This can be more dangerous if the security has not shown signs of stabilization or accumulation.
Traders use a wide variety of technical metrics to determine whether an asset is oversold. A sharp price drop, by itself, is insufficient to determine when selling is exhausted, and prices may continue to fall further.
Limitations of the Exhausted Selling Model
When the price is falling, it may continue to fall even if the guidelines of the exhausted selling model are met. There may be a dead cat bounce, as traders attempt to buy the dip, before prices continue to fall. A large decline doesn't necessarily mean a security is worth purchasing at the current price. In many cases, these drops occur due to fundamental reasons and market conditions.
The model itself doesn't predict how far the price will bounce or for how long. It is up to the trader to determine when to exit profitable trades. Risk can potentially be limited with a stop-loss, but in fast-moving market conditions, the stop-loss may be subject to slippage, resulting in a larger loss than anticipated.