What does 'Whipsaw' mean
Whipsaw is a condition in which a security's price heads in one direction, but is followed quickly by a movement in the opposite direction. There are two types of whipsaw patterns, with the first involving an upward movement in a share price, which is then followed by a drastic downward move, causing the share's price to fall relative to its original position. The second type occurs when a share price drops in value for a short while, and then suddenly surges upward toward a positive gain, relative to the stock's original position.
BREAKING DOWN 'Whipsaw'The origins of term Whipsaw derives from the push and pull action used by lumberjacks to cut wood with a type of saw of the same name. A trader is considered to be "whipsawed" when the price of a security he just invested in abruptly moves in the opposite direction of what was expected. As one would surmise, whipsaw patterns most notably occur in a volatile market in which price fluctuations are unpredictable.
The act of getting whipsawed is most common for day traders or other short-term investors. Those who have a long-term, buy-and-hold approach to investing are often able to ride the volatility of the market and come out on the other side with positive gains.
Two Examples of a Whipsaw
The first example of a whipsaw is also the most likely to occur. When an investor goes long on a stock, he buys it with the expectation that it will increase in value over time. However, there are many occasions in which an investor purchases shares of a company at the top of a market rally. For example, an investor may purchase a stock at its peak, assuming that it will continue to post big gains. Almost immediately after purchasing, the company comes out with a quarterly report that shakes investor confidence and causes the stock to decline in value by more than 10%, never to recover. The investor is holding the stock at a loss, with no way of getting out, effectively whipsawed.
Conversely, some investors, specifically those who short-sell, can face a whipsaw at the bottom of a market. For example, an investor may see the economy headed for a downturn and purchases put options on the S&P 500. He'll profit if the market continues to decline. However, almost immediately after purchasing the put options, the market unexpectedly rallies and his options quickly become "out of the money," or worthless. In this case, the whipsaw occurs during a recovery phase, and the investor loses his investment.