Exhausted Selling Model

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 — or when sellers have exhausted their ability to sell any further. It is employed by investors who seek to profit from a turnaround following a period of intense selling pressure.

Exhaustion happens when nearly everyone who needs to be long or short already is, leaving very few people to support or continue pushing the price in the current direction.

Understanding the Exhausted Selling Model

The exhausted selling model is well-suited for periods following uncommonly intense selling, otherwise known as panic selling. In these circumstances, contrarian investors can profit by "buying the dips" at strangely 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 could face panic selling in response to a negative talk from a continuous legal battle. On occasion, panic selling can produce price declines that are definitely more severe than warranted by the news item that triggered the panic.

In these circumstances, 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 may be approaching. Because it is principally based on price chart information, the exhausted selling model is generally used by traders who follow a technical analysis approach to trading.

Technical Analysis

The exhausted selling model is like techniques used by value investors, who search for bargain opportunities by monitoring companies with low price-to-book (P/B ratios), low price-to-earnings (P/E) ratios, and comparable metrics. However, the exhausted selling model differs from these techniques because it is based exclusively on the price history of the security rather than on its fundamentals.

Special Considerations

Albeit different investors could use modified versions of the exhausted selling model, most versions involve the following guidelines:

• To start with, the security in question must have recently declined based on uncommonly high trading volume.
• Second, there must be recent evidence of buying pressure (following the decline, for example, a bullish engulfing pattern or any type of bullish chart pattern inside the price or in a technical indicator.
• Third, the stock tests a support area, for example, an important moving average (MA) or a price where the security bounced off on prior declines, signaling a base of demand from buyers.

Assuming that 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 before long take place.

As indicated, these are general guidelines, and individual traders may trade varieties of this model utilizing technical tools of their preference. Once a trader buys based on the alignment of the guidelines, a stop-loss order can be placed below the recent swing low to control risk.

Example of the Exhausted Selling Model

The following daily chart of ROKU Inc. (ROKU) shows a huge uptrend followed by a sharp, high-volume price decline.

A trader using 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 likewise dropped below the 100-day moving average — which some traders view as important — and afterward 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 versus Catching a Falling Knife

The exhausted selling model is used to buy securities whose price has fallen but likewise exhibits positive technical characteristics of a bounce. This is distinct from catching a falling knife, an informal term for buying a sell-off without concentrating on technical indicators. This can be more dangerous on the off chance that the security has not given indications 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 assuming 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. As a rule, these drops happen 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 might 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.

Highlights

• The exhausted selling model relies on price and technical information, like recent trading volume, support, and candlestick or chart patterns.
• The goal is to identify securities that have seen intense selling pressure, to such an extent that there are no more sellers left.
• Once selling has been exhausted, a trader utilizing this model hopes to buy into a trend reversal.
• The exhausted selling model is used by traders searching for oversold securities or markets.