What Is Panic Selling and How to Profit From It

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What Is Panic Selling and How to Profit From It

Panic selling happens when the price of a stock falls fast on large volume. This often occurs when an incident pushes investors to reconsider the company’s fundamental worth, or when short-term traders are able to drive the stock price low enough to trigger long-term stop-losses.

Bottom fishers have a fantastic chance to establish long positions as a result of the whole process, particularly if the event that caused the panic selling was non-material or speculative in character (such as aninvestigationby theSEC or an analyst opinion).We shed light on the panic-selling process and propose a methodology that may assist you in predicting the best moment to enter a long position once panic selling happens.

How Does Panic Selling Occur?

There are various stages to panic selling. The picture below depicts a typical panic selling situation as a consequence of an SEC inquiry. Doral Financial, a firm whose core business was mortgage banking until folding in 2015, is the company in this case. This figure may be seen as a generic representation of what occurs in panic-selling circumstances.

Image by Julie Bang © Investopedia2021

Let’s go through what occurs at each numbered step in the diagram:

Step 1: Something happens that causes the stock price to drop swiftly on high volume.

Step 2: At some point, a high volume day arises as buyers and sellers compete for control of the trend. On low follow-up volume, the winner then takes the trend.

Step 3: If there is no big trend shift at point 2 (i.e., a continuation), there is usually another point of high volume when a large reversal (long or short term) may occur.

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Step 4: This approach is repeated until a long-term trend is developed and supported by technical or fundamental considerations.

Now we’ll look at how we can forecast when a trend may shift.

The Exhausted Selling Model

To assess whether a price floor has been reached, the exhausted selling model (ESM) was created. This is accomplished by combining the following trend, volume, and turnaround indicators:

The image below illustrates how this model works.

Exhausted selling model.

Image by Julie Bang © Investopedia2021

It is worth noting that a number of indicators are utilized to establish that the trend has shifted. As a trader, you have the option of using as many confirmation indicators as you choose. The fewer confirmation signs employed, the greater the risk and the greater the return (i.e., the longer you wait for confirmation, the less potential gain there will be for you to catch), and vice versa.

The rules to using the ESM include:

  • The stock price must first fall swiftly on big volume.
  • A surge in volume will occur, generating a new low and seeming to reverse the trend. Here, look for candlestick patterns indicating a battle between buyers and sellers (i.e., cross patterns or engulfings).
  • A higher low wave must occur.
  • A break in the major negative trend line is required.
  • The moving averages of 40 or 50 days must be breached.
  • After then, the 40- or 50-day moving average must be retested and held.

You may also employ various moving averages, preferably ones that link highs and lows. A break of a bigger moving average is usually more suggestive of a trend break than a break of a smaller moving average.

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As you can see, the ESM employs a number of strategies to guarantee that the trend is altered in the long run.

Now, consider the figure below, which depicts the ESM in action.

Chicago Bridge & Iron (CBI), which merged with McDermott International in 2018, reported a delay in profits, sending the stock down 16 percent in a couple of hours. First, we can observe that the low was recorded at high volume just before 11:26 a.m. Following that, the price rises slightly before forming a falling triangle, from which we built a trend line (indicated here by the blue line).

The price then breaches the trend line and moving averages (indicated by the blue dot on the left).It then retraces to the moving averages (shown by the blue dot on the right) before continuing to rise.

Image by Julie Bang © Investopedia2021

Finally, we can observe that when all of the confirmations are present, CBI turns around and returns to its prior values. It is worth noting that if you had joined after just one or two of the indications, you would have gained more money but increased the risk of the transaction.

The Bottom Line

Panic selling, by definition, generates excellent buying opportunities for knowledgeable traders and investors. Those who recognize when the selling is finished might profit from the retracements/turnarounds that often follow. The ESM described here is a safe and effective way for determining the optimal entry point, and its utilization of many indications may help you avoid expensive errors.

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