What Is Whipsaw?
Whipsaw describes the movement of a security when, at a particular time, the security's price is moving in one direction but then quickly pivots to move in the opposite direction.
There are two types of whipsaw patterns. The first involves 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 time and then suddenly surges upward to a positive gain relative to the stock's original position.
- Whipsaw describes the movement of stocks in a volatile market when a stock price will suddenly switch direction.
- There is no set rule as to how to manage whipsaw movements in a volatile market as it is an unexpected movement.
- Whipsaw in trading securities often results in trading losses.
- Day traders expect whipsaw movements and often assume long-term, buy and hold positions to ride out the fluctuations in price to avoid a loss.
The origin of the term whipsaw is derived from the push and pull action of lumberjacks when cutting wood with a saw of the same name. A trader is considered to be "whipsawed" when the price of a security they have just invested in abruptly moves in the opposite and unexpected direction.
Whipsaw patterns most notably occur in a volatile market in which price fluctuations are unpredictable. Day traders or other short-term investors are accustomed to being whipsawed. Those who have a long-term, buy and hold approach to investing can often ride out the volatility of the market and emerge with positive gains.
For example, when an investor goes long on a stock, the expectation is that the price will increase in value over time. However, there are many occasions when an investor purchases shares of a company at the top of a market rally. The investor buys a stock at its peak assuming that it will continue to post significant gains. Almost immediately after purchasing the stock, the company releases 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 option to sell the stock, 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 anticipate a downturn in the economy and purchase put options on the S&P 500. The investor profits if the market continues to decline. However, almost immediately after purchasing the put options, the market unexpectedly rallies, and the investor's options quickly become "out of the money," or worthless. In this case, the whipsaw occurs during a recovery phase, and the investor loses the investment.
Financial markets change abruptly. Many analysts seek models that explain patterns in the markets so that an investor can select the right asset classes. A study by Sonam Srivastava and Ritabrata Bhattacharyya, titled, "Evaluating the Building Blocks of a Dynamically Adaptive Systematic Trading Strategy," explains that stock patterns vary because of fundamental changes in macroeconomic variables, policies, or regulations.
The authors state that a trader needs to adapt their trading style to leverage the different phases in the stock markets. They also suggest that investors select asset classes in different market regimes to ensure a stable risk-adjusted return profile. However, different experts will offer different advice.
A whipsaw references any price movement that is in the opposite direction of a trader's intended bet, often resulting in a loss, or if they are able, to ride out the fluctuations in price to maintain the investment and even realize a profit.
Real World Example
Stocks have whipsawed recently due to uncertainty about the future of the economy, rising inflation, and geopolitical unrest.
To weather the volatility, experts recommend that investors stick to a long-term strategy that plays to their strengths and follow that strategy regardless of whipsaw movements. In terms of investment, another expert recommended investing in more stable sectors such as healthcare and avoiding more volatile sectors such as real estate. Most experts were expecting significant volatility in the short term, and one recommended assuming a defensive position. However, they did also state that a long-term portfolio based on the stock would win out.
How Can Traders Profit from Whipsaws?
While it may look like a sideways market, whipsaws imply that there are large up and down swings within a certain trading band. This can be profitable for swing traders who can catch momentum both up and down as the market oscillates. Buying long straddles in the options market is another strategy that can profit as prices move both up and down.
How Can Whipsaws Hurt Traders?
Whipsaws can cause losses for traders by triggering closing trades, only to be reversed in short order. Traders are often stopped out when a market whipsaws, or moves sharply in one direction before returning to its original state. For example, a stock may whipsaw during an earnings announcement or other market moving event. This can execute stop-loss orders that close out positions, even as the stock subsequently rebounds.
What Technical Indicators Can Be Used to Spot Whipsaws?
Certain technical indicators are useful in identifying a whipsawing market. Envelopes, momentum indicators, parabolic SAR, and the vortex indicator are some good examples.