What is 'Shakeout'

A shakeout is a situation in which many investors exit their positions, often at a loss, because of uncertainty or recent bad news circulating around a particular security or industry. During the dotcom boom and bust, numerous shakeouts occurred. During these shakeouts, many investors experienced tremendous losses.

BREAKING DOWN 'Shakeout'

A shakeout often happens when a leading stock corrects in price. This is called a final shakeout. In such a situation, institutions step in to buy shares and the stock works its way higher along the right side of the base. Higher prices will usually attract a few remaining sellers that want to cash out quick profits or get out near break-even for those who bought near recent highs. This halts the stock's advance and leads to a pullback.

The price action in the pullback should be light relative to the rest of the base. Volume should dry up with an exhaustion of supply into the market. The handle, in most cases, should correct no more than 8 to 12 percent in price, unless it is part of a very large cup, or if the handle was formed during a bear market. In these cases, the decline can be larger.

A proper handle should also form in the upper half of the overall base. This demonstrates having enough power to rise significantly off the base before starting a final pullback. Stocks that run up straight from the lows of the base into new high ground without pausing to form a handle are more failure prone. On a chart, the base adopts a 'V' fashion.

For example, if a stock corrects 25 percent, it will need to rise 33 percent to get back to its recent high. A stock that rallies 33 percent without pausing will be more prone to a sharp sell-off than a stock that has gone through a proper final downward drift in price.

Price action should drift lower along the handle's price lows to mark a proper shakeout; volume should be mostly below average. Handles that wedge upward toward new highs, or see excessive selling volume should be avoided.

Handles most commonly form on cup bases, but can also form on other patterns such as double-bottom and saucer bases.

Shakeout Example

In January 2013, 18 months after its IPO, LinkedIn broke out from its first proper base, and the pattern ran for 16 weeks and had a constructive rounded cup with downward-sloping handle.

When volume dried up sharply in the week ending Dec. 28, 2012, very little supply was coming into the market. The next week, LinkedIn remained virtually unchanged, which allowed a powerful breakout to happen

Volume surged 55 percent above average on Jan. 10, 2013, when the stock cleared the 117.42 buy point, which is exactly what you want to see. Once the stock broke out, it never again closed below the buy point, establishing a new base as it ran up 119 percent over the next eight months.

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