Scare selling occurs when a stock price rapidly declines on high volume. This often happens when some episode forces investors to re-evaluate the stock’s intrinsic value, or when short-term traders are able to force the stock reward down far enough to trigger long-term stop-losses.
The entire process creates a tremendous opportunity for bottom fishers to novice long positions, especially if the event behind the panic selling was non-material or speculative in nature (such as an investigation by the SEC or an analyst appraisal). Here, we shed light on the panic-selling process and introduce a model that can help you predict the right time to cheat a long position after panic selling occurs.
How Does Panic Selling Occur?
Panic selling materializes in several phases. The image below illustrates a typical panic selling scenario that occurred as a result of an SEC search. The company in this example is Doral Financial, a corporation whose primary business was mortgage banking before imperfection in 2015. This chart can be read as a general illustration of what happens in panic selling situations.
Let’s infringe down what happens at each numbered step in the chart:
Step 1: Something occurs that causes the assortment price to rapidly decline on high volume.
Step 2: Eventually, a high volume day occurs when buyers and sellers strive with 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 promontory 2 (i.e., a continuation), then there is typically another point of high volume in which a substantial reversal (lengthy or short term) may occur.
Step 4: This process continues until a long-term trend is established and confirmed with intricate 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 dead on ones feet selling model (ESM) was developed to determine when a price floor has been reached. This is done by using a amalgam of the following trend, volume and turnaround indicators:
The image below illustrates how this model works.
Notice that a variety of indicators are used to confirm that the shift has changed. As a trader, you may choose how many confirmation indicators you wish to use. The fewer confirmation indicators used, the higher the jeopardize and the higher the reward (meaning the longer you wait for confirmation, the less potential gain there will be for you to capture), and depravity versa.
The rules to using the ESM are:
- The stock price must first rapidly decline on high volume.
- A volume balk will occur, creating a new low, and appear to reverse the trend. Look for candlestick patterns showing a struggle between customers and sellers here (i.e., cross patterns or engulfings).
- A higher low wave must occur.
- A break of the predominant downward vogue line 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 preside over.
Note that you may use other moving averages—ideally, ones that connect highs or lows. Typically, a defy of a larger moving average is more indicative of a trend break than smaller moving averages.
As you can see, the ESM combines disparate techniques to ensure that the trend has changed for the long term.
Now let’s take a look at the image below, which desire show the ESM in practice.
Chicago Bridge & Iron (CBI) (which merged with McDermott International in 2018) announced that its earnings drive be delayed, which sent the stock down 16 percent in a matter of hours. First, we can see that the low was made on momentous volume just before 11:26 a.m. Next, the price moves up slightly, but eventually forms a descending triangle, from which we lugged a trend line (indicated here by the red line). Next, the price breaks through the trend line and moving customaries (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 distribute. Note that if you would have entered after just one or two of the indicators, you would have made more profit, but increased the chance of the trade.
The Bottom Line
Panic selling naturally creates great buying opportunities for well-informed traders and investors. Those who comprehend when the selling is over can benefit from the retracements/turnaround that often occur afterwards. The ESM explained here affords 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 wrong moves.