What is whipsaw in trading and investing?
In trading and investing, whipsaw refers to the price of a financial asset (such as a security), moving sharply in one direction but then suddenly change course to move in the opposite direction.
Whipsaw differs from other reversals because it represents a sudden change in a security’s momentum, which occurs in a short time after a trader/investor has entered a trading position.
Whipsaws can occur in down markets as well as in up markets, typically, classified into two types of whipsaw patterns:
- The first type occurs when the price of a financial asset decreases in value for a short time and then suddenly leaps upward to a positive gain relative to the financial asset’s original position.
- The second type involves an upward movement in a financial asset’s price, which is then followed by a sharp downward move, causing the asset’s price to decline relative to its original position.
Whipsaw patterns primarily occur in volatile markets where prices fluctuate unpredictably and where traders are subjected to high risk.
A trader or investor is deemed to be ‘whipsawed’ when the price of a financial asset (security) he/she has just bought or invested in, suddenly moves in the opposite – and unexpected – direction. Typically, a trader ‘whipsawed’ by the market incurs a loss due to his/her inability to react quickly enough to unfavourable market changes.
Put differently, a trader has been ‘whipsawed’ if he/she buys financial assets just before they decline in value, and/or sells them before they increase in value in a volatile market. This may happen due to misleading signals or information, or decisions based on emotions or fear.
Put simply, financial markets or financial assets (securities) that whipsaw can cause losses if traders enter or exit their positions (long or short) at the wrong time.
The Free Dictionary also defines whipsaw as: ’To buy securities at a market top or to sell at a market bottom. That is, one whipsaws when one buys or sells securities at exactly the worst possible time. One whipsaws out of fear or misreading market signals. To whipsaw is also called to chatter.’ (Accentuations in the quote are by the article writer.)
The term ‘whipsaw’ originates from the timber (logging) industry. According to the Merriam-Webster Dictionary, ‘a whipsaw is a type of hand-powered saw worked by two people, one of whom stands on or above the log being sawed and the other below it, usually in a pit. The tool dates back to the 15th century, but it was not until the 19th century that anyone thought to use the saw’s name figuratively to describe situations in which someone or something is doubly “cut,” or hurt.’
As a financial term, whipsaw refers to the push and pull action that woodcutters (lumberjacks) use when cutting logs with a whipsaw.
How to identify or avoid whipsaws
Short-term investors, day traders, and speculators are more likely to suffer losses from a whipsawed market than long-term investors, who are normally able to ride market volatility, ending up with better results over a longer period of time.
Whipsaw often occurs when a financial asset (security) is either oversold or overbought. Typically, trend traders purchase securities that have been moving upward or short selling securities that have been losing value. Sometimes, too many traders buy specific securities (such as shares of companies), and they get ‘overheated’ in terms of demand.
Overbought or oversold shares refer to ones that analysts consider not trading at their fair value. Overbought shares have too much buying demand, selling above their fair value. Contrarily, oversold shares may be worth more than its current trading price.
Overbought shares (financial assets) could suffer a sudden decline in price, while oversold shares could experience a sudden surge in price.
Shares that are ‘overheated’ are exposed to whipsaw risk because the further price move away from fair value, the fewer traders there will be who are willing to buy or sell the shares. When the number of traders decline significantly, and traders begin to take profits simultaneously, a whipsaw can occur.
Whipsaws are a part of trading and cannot be wished away or be ignored.
Knowing how to identify or avoid whipsaws can help traders and investors considerably avoiding losses caused by whipsaws.
- How to identify a potential whipsaw
The following advice may help you to identify a potential whipsaw effect in a financial market: Be watchful for the price of a financial asset suddenly changing against the prevailing trend in a financial market.
Although difficult to identify this sudden change before it has occurred, a trader or investor can apply analyses, such as technical analysis and fundamental analysis, before opening a trading position. These analyses enable a trader/investor to determine whether a financial asset is currently oversold or overbought.
When an asset is overbought, a trader or investor might encounter whipsaw when taking a long position. Conversely, when the asset is oversold, a trader/investor might be subjected to whipsaw when going short.
One method to identify an overbought or oversold financial asset is to use the Relative Strength Index (RSI) technical indicator. The RSI indicator measures how quickly an asset is moving in either direction relative to how it performed in the past. The indicator ranges between 0 and 100, with levels below 30 regarded oversold and above 70 considered overbought.
- How to avoid whipsaw in trading and investing
To keep away from whipsaws in trading, traders and investors need to know the market he/she intends to trade, implement analyses (fundamental and technical – similar to when identifying a potential whipsaw), and formulate a trading strategy.
In addition, set stop-losses when opening positions, enabling you to minimise losses if you experience a sudden whipsaw.
A demo trading account can be helpful to practise avoiding whipsaws. Demo trading accounts – offered by professional and regulated brokers – provide a risk-free environment that can be used to trade new markets and to try out new trading strategies. Also, trading is executed with virtual funds, implying no real money is at risk when trading on a demo account.
Impact of whipsaw on trading strategies
Whipsaw can effect trading strategies in different ways, as described below:
- Trend following
Trend following refers to a trading strategy assuming that the price of an asset will continue to move in a specific direction for an extended period of time. Traders who execute trend following as a strategy can be whipsawed out of a trading position if they purchase when an asset is overheated.
Experienced trend followers typically use technical indicators like RSI to decide whether it is time to close a trading position.
- Scalp trading
Scalp trading, also referred to as scalping, is a trading strategy applied by day traders, aiming to profit from small changes in the prices of financial assets – like shares. Scalpers use whipsaw movements to make money by waiting for the whipsaw to occur and then buy shares after the sudden drop to ride the price move back up.
Typically, scalpers generate quick profits off high volumes of shorter trades, which can last only seconds or minutes.
Swing trading is a trading strategy practised by traders referred to as swing traders, using momentum indicators to profit from market swings ranging from one day to several weeks.
Swing traders can be whipsawed when they open a trading position at an unfavourable time and when a financial asset immediately whipsaws against them.
To protect them against whipsaws, swing traders can use volume indicators to determine whether a potential financial asset may be advancing toward a whipsaw movement.
- Buy-and-hold strategy
Buy-and-hold strategy is a long-term investing strategy in which investors buy financial instruments and hold them for the long term.
Usually, long-term investors are not affected by whipsaw movements. Short-term decreases that are rectified in a few days, weeks, or even months, simply do not matter.
Whipsaw example
Let us say, that a trader has just taken a long position on shares of company ABC because the price has been increasing consistently. Soon after the move by the trader, the board of directors of ABC make an announcement concerning corruption by the chief financial officer (CFO) of the company.
The announcement causes a sudden fall in the price of the shares. Since the trader has entered a long position, expecting that the price will rise, this will mean that the trader either loses a proportion of his/her profits, or the trader could suffer an outright loss.
Note: This article does not constitute investment, financial or trading advice. Please obtain the advice of a professional and regulated broker before making trading and investment decisions.
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