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March 07 2012| Filed Under Active Trading, Banking, Technical Analysis
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:
Trendlines
Volume
Moving Averages
Chart Patterns
Figure 2 illustrates how this model works.
Figure 2: Exhausted selling model
Source: ChartSetups.com
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.
Example
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
Source: ChartSetups.com
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.
by Justin Kuepper
Justin Kuepper has many years of experience in the market as an active trader
and a personal retirement accounts manager. He spent a few years independently
building and managing financial portals before obtaining his current position
with Accelerized New Media, owner of SECFilings.com, ExecutiveDisclosure.com
and other popular financial portals. Kuepper continues to write on a freelance
basis, covering both finance and technology topics.