What is 'Whipsaw'?

Whipsaw describes the movement of a security when, at a certain 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.

BREAKING DOWN 'Whipsaw'

The origins of the term whipsaw are 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 he has 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 the volatility of the market and emerge with positive gains.

Two Examples of a Whipsaw

One example of a whipsaw is also the most common. 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. For example, an investor may purchase 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 his investment.

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