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 an investigation by the SEC 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.

How Does Panic Selling Occur?

Panic selling happens in several phases. Figure 1 illustrates a typical panic selling scenario that occurred as a result of an SEC investigation. The company in this example is Doral Financial, a corporation whose primary business was mortgage banking before failing in 2015. 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:

Trend lines

Volume

Moving Averages

Chart P

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 (meaning 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:

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 trend 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 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 (CBI) announced that its earnings would be delayed, which sent the stock down 16 percent 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 trend line (indicated here by the red line). Next, the price breaks through the trend line 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 ESM 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.

(For more, read How the Power of the Masses Drives the Market.)