Writing about "The Selling Climax" in Technical Analysis Of Stock Trends, authors Robert Edwards and John Magee observe that:

Most true Selling Climaxes, if not all, have been produced by distress selling ... They have come at the end of rapid and comprehensive declines which exhausted the margin reserves of many speculators and necessitated the dumping of their shares at whatever the market would bring. This process is progressive -- feeding upon itself, so to speak -- with each wave of forced sales jeopardizing another lot of margined accounts, until at last millions of shares are tossed overboard, willy-nilly, in a final cleanup.
Bad? Good? Indifferent? For Edwards and Magee, it depends on where you stand as a trader.
Such is a Selling Climax in which the total turnover may exceed any single day's volume during the previous upswing. It is a harvest time for traders who, having avoided the bullish infection at the top of the market, have funds in reserve to pick up stocks available at panic prices.
It is hard to overstate the value of Edwards and Magee's book when reading through chapters like "The Selling Climax." An instructional guide, a market history, and a tem plate for sound trading, Technical Analysis Of Stock Trends was, interestingly, one of the few sources I could find that spent a good deal of time dealing with the market phenomenon known as the selling climax.

Edwards and Magee begin the discussion with a look back to the "bad old days" of bear raids and market manipulation, when the absence of short-selling restrictions and a more casual attitude about insider trading made classic selling climaxes relatively more frequent.

However, as they note, "margin calls and forced selling will, of course, always exist as a market factor so long as stocks can be bought on margin, and will come into play whenever prices drop extensively following a spree of public buying." And while Edwards and Magee suggest that one helpful way of recognizing selling climaxes might be to "have friends in the street ... keep you informed on the condition of margin accounts and the amount of necessitous selling to be expected," there are a few other more practical clues and cues to help spot these major market events when they happen.

What sort of clues? First, it is important to recognize that not every selling climax represents the end of a bear market phase. As Edwards and Magee remind us, selling climaxes involve a final "shaking out" of bullish holdouts, and "weak holdings usually have been shaken out long before that [bear market bottom] stage is reached." Usually, however, is not always, as those traders and investors who experienced the selling climax on September 21 (the fifth day of trading after the markets were closed due to the September 11th terrorist attacks in the US) could tell you. In many respects, September 21 was both a classic selling climax and a very atypical bear market bottom. See Figure 1.

Figure 1: DJIA. In the wake of the September 11th terrorist attacks in the US, the Dow Jones industrials saw a wave of selling in the first few days, a wave that culminated with a selling climax on September 21 that paved the way for buyers new and old.

What can we glean from this example? The first prerequisite of the selling climax is that it occurs on overwhelming volume. Edwards and Magee go so far as to say that the volume during the selling climax could easily rival that of the volume of any single day during the advance that preceded the decline.

Another prerequisite has to do with the notion of the decline. By definition, selling climaxes can occur only after some period of previous selling. This previous selling, or prevailing downtrend, is what sets the stage for the "feeding upon itself" phenomena that Edwards and Magee wrote about. Noting the chart of the Dow Jones Industrial Average (DJIA) back in the late summer and early autumn of 2001, it was clear that as the DJIA broke beneath support at the end of August, that break was part of a broader downtrend that began in the spring. Even after September 11, it took four days of relentless selling before sellers exhausted themselves on the fifth day.

Other than volume and duration, additional clues can help spot selling climaxes in stock indexes and individual issues. Positive divergences with oscillators are a proven way of improving the risk/reward ratio when gaming market bottoms (though there was no positive divergence on September 21 using the 7,10 stochastic). And as I have written elsewhere, the moving average convergence/divergence histogram (MACDH) extremes can also play a role in helping determine whether a decline has been severe enough to possibly create a bottom. Japanese candlesticks that portend bullish reversals such as the hammer, bullish engulfing, morning stars, and bullish piercing patterns can all be used in combination with the tools already mentioned to provide further confirmation for a potential selling climax.

There is one last note before taking a look at some selling climaxes and potential selling climaxes in individual stocks. Writing in his Trading For A Living, trader and educator Alexander Elder observes, "Climax bottoms are usually retested." Again, "usually" except when they are not -- nevertheless, as we will see in some of the examples, being prepared for a test -- as well as exiting as soon as the prospective selling climax low is breached -- is an important task for anyone trying to "cash in a few days later with exceptional profits," to quote Edwards and Magee.

Figure 2: LIFEPOINT HOSPITALS. The mid-August selling climax in shares of Lifepoint Hospitals had many features that would have tipped off bargain-hunting traders that the swift, sharp declines would soon be over. Candlestick patterns, MACDH extremes, a positive stochastic divergence, and the abilities of the stock to not move below the lows of the climax day were all contributing clues.

Figure 2, which shows the chart of Lifepoint Hospitals (LPNT), is an excellent example of a selling climax in an individual stock. Lifepoint topped in June with a closing high near 39; prices corrected sharply late in the month, shedding five points before rallying back above its 50-day exponential moving average (EMA) in July. However, Lifepoint was unable to set a new high in July, and by the end of the month, it was once again fading below the 50-day EMA. While there were few instances of above-average volume, most of the trading in LPNT was on average volume throughout this period.

Note, however, the technical deterioration that becomes impossible to ignore in late July and early August as volume picks up a few times during the last few trading days of July. The first half of August saw prices fail to move up and test the 50-day EMA for resistance. The selling climax in Lifepoint came swiftly as prices gapped down by nearly four points on thoroughly overwhelming volume (that is, more than 10 times typical volume). This is the kind of volume spike that traders can spot a mile away. And given the kind of volume in which LPNT tends to trade, value-oriented traders could have easily put Lifepoint on their watchlists as a stock to watch if its post-break, post-selling climax lows held.

Consider also some of the other technical aspects of Lifepoint's breakdown that signaled to traders that a selling climax had occurred. The long lower shadow on the gap down day -- in combination with the overwhelming volume spike -- was a major clue that not only had everybody who wanted to sell the stock done so, but also that the selling was unable to keep prices depressed. Again, note that prices gapped down several points to open near 29, declined intraday to less than 27, then rallied into the close near 28.

There is also a shorter-term positive divergence between prices of LPNT in August and the 7,10 stochastic oscillator. Unfortunately, selling climaxes are not always accompanied with positive stochastic divergences. But when those divergences occur alongside some of the other technical factors already mentioned, they can be powerful clues and are worth watching. Finally, consider the MACDH extreme that developed during the August lows. As I have written for Working Money, MACDH extremes to the downside often suggest further declines after a significant countertrend bounce. That bounce is the rally that traders looking to buy selling climaxes are counting on.

Figure 3: GENERAL MOTORS. Many factors suggested that General Motors was not experiencing a selling climax in mid-October. But the key factor was that the lows of the selling climax day did not hold up and were penetrated to the downside shortly afterward.
Briefly, I'd like to compare Lifepoint's selling climax with a selling climax in General Motors (GM) stock that never really worked out. As Figure 3 shows, GM was in a major downtrend in the late summer of 2004, trending below its 50-day EMA for all but three or four days from July through September. Then, in October, just as prices were drifting downward toward a test of support at 41, prices gapped down on more than double average daily volume. This alone would have been enough to get traders' interest piqued, but would it have been enough for a "selling climax" trader to pull the trigger?

The big volume on the gap down day is a good argument for a selling climax, but it appears as if the climax would have failed the initial test of not holding its lows. The low of the selling climax day was penetrated the following day and, within three days, GM had registered a lower low (vis-à-vis the selling climax day). In fact, GM lost almost another two points after the day that coulda, woulda, shoulda (maybe) been a selling climax. In addition, there was no positive divergence, nor was the MACDH trough significantly extreme (the MACDH trough in July dipped lower). A trader trying to play this gap down on big volume as a selling climax buy most likely would have exited with a small loss, but also with the confidence and reassurance that no outsized risks were taken. Even as GM rallied along with the broader market over the balance of October and into November, prices never managed to climb back above the gap down "zone" between 41 and 40.

I plead guilty to a slightly less than completely healthy fascination with tops and bottoms, while the majority of traders rightly encourage their peers to stick with the trend ("your friend until the end"), focusing on the "meat in the middle," as Market Wizard Randy McKay put it. Nevertheless, as long as tops and bottoms exist in the market to be played, traders will seek them with new tools and analytic techniques to play them. As Victor Sperandeo wrote in his book, Methods Of A Wall Street Master:

The fastest and most risk-free way to make money in the markets is to identify a change of trend in a market as early as possible, take your position (long or short), ride the trend, and close your position before or shortly after the trend reverses again.
There is no greater symbol of a change of trend than a selling climax. And while not every crescendo is a climax, observant and patient traders will be able to turn the occasional market crash into some real cash.

David Penn is Technical Writer for Stocks & Commodities.

Suggested reading
Edwards, Robert D. and John Magee [1966]. Technical Analysis Of Stock Trends, John Magee, Inc.
Elder, Alexander [1993]. Trading For A Living, John Wiley & Sons.
Kamich, Bruce M. [2003]. How Technical Analysis Works, New York Institute of Finance/Prentice Hall Press.
Nison, Steve [1994]. Beyond Candlesticks, John Wiley & Sons.
Sperandeo, Victor [1991]. Methods Of A Wall Street Master, John Wiley & Sons.
ýSee Editorial Resource Index

Excerpted from an article originally published in the February 2005 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2005, Technical Analysis, Inc.

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