Definition of Whipsaw in Investment
Whipsaw in investment occurs when a stock, market, or trading index exhibits a certain movement and then quickly moves in the opposite direction. Markets or securities that show a clear movement can lead to trading losses if traders enter or exit their positions at the wrong time.
Definition and Examples of Whipsaw in Investment
Whipsaw in investment occurs when the price of an asset or index rapidly moves in the opposite direction from what it was. Whipsaw can occur in both bullish and bearish markets.
Whipsaw in Bullish Markets: Whipsaw in bullish markets occurs when a market or security generally experiences upward price movement, then sees a sudden decline before resuming its upward trajectory.
Whipsaw in Bearish Markets: When a certain index or security declines but suddenly reverses to rise for a short duration before continuing its downward path, it is referred to as whipsaw in bearish markets.
When a stock moves sharply in one direction and then moves sharply in another direction, it is referred to as whipsaw. Although whipsaw generally means that the asset is moving against the prevailing trend (increasing during a downward trend or decreasing during an upward trend), it is also used for assets that have no specific direction.
A good example of a stock that experienced whipsaw trading even though it had no specific direction is Coinbase (COIN). On its first trading day on April 14, 2021, it opened at $381, then rose to more than $429.54, then dropped sharply, ending the day at $328.28. Those sharp increases and decreases were whipsaw movements.
A trader is exposed to whipsaw if they buy a security right after its price drops or sell a security before its price rises, leading to losses.
So in the example above, if a trader opened a position in COIN stock at $400, saw profits for a brief period, then watched it drop to $328, the trader would be taken out of their position due to whipsaw. Whipsaw losses are a common part of trading.
Note: Traders use stop-loss orders to protect themselves so that their broker automatically sells the stock if it drops below a certain level. This limits large losses, but in the case of whipsaw where the stock drops quickly and then returns to an upward trend, it sells a position that the trader might have held had whipsaw not occurred.
The final example is trading indexes. If a trader opens a position because the index showed something and the index immediately changes to show a sell signal, the trader has been whipsawed out.
How Whipsaw Works in Investment
Whipsaw often occurs when a stock is overbought or oversold. Trend traders buy stocks that have risen and sell stocks that have fallen. Sometimes, many traders accumulate on these stocks and become “overly excited.” Overbought stocks are those that have a very high buying demand and have traded above their fair value. Oversold stocks are the opposite.
Stocks that are hot are prone to whipsaw because the further they are from fair value, the more traders follow demand or supply on the stocks. When there aren’t enough traders, and traders start taking profits collectively, whipsaw can occur.
Note: One way to determine if a stock is hot or oversold is by using the Relative Strength Index (RSI) technical indicator. The RSI measures how quickly a stock is moving in either direction compared to what it has done in the past. The RSI ranges from 0 to 100. Levels below 30 are considered oversold, and levels above 70 are considered overbought.
Stocks
Stocks that are trending upward but have the relative strength index in an overbought zone may continue to rise, but they may also be prone to a whipsaw back to a more normal region. The reasons for the current increase in buying demand can be evaluated to determine whether you should wait for better RSI numbers.
What This Means for Individual Investors
Sudden price movements, especially unexpected reversals, can affect portfolios and make investors nervous. Here’s how the impact of whipsaw affects common trading strategies:
Trend Following: Following the trend may be halted when trend followers buy stocks that are overbought. Experienced followers use technical indicators like RSI to determine if it’s time to buy or sell positions.
Range Trading: Range traders use momentum indicators to ride the trend over a period of a few weeks. Whipsaw can affect range traders when they enter a position at a bad time and the stock immediately moves against them.
Scalping: This is a type of day trading where traders target many small profits and move quickly in and out of stocks. Whipsaw movement is a key element for many scalpers. They wait for a whipsaw to occur and then jump into the stock after a sharp decline to capture the bounce.
Long-Term Investing: Long-term investors typically shouldn’t be concerned with whipsaw by definition. If their expected holding period in a stock may reach ten years, or even forever, short-term declines that correct in a few days, weeks, or months simply don’t matter.
Takeaways
Whipsaw in investing is when a stock or index moves rapidly in the opposite direction of expectations. Traders can lose profits when they are stopped out of their positions due to whipsaw. Trading indicators that show whether a stock is overbought or oversold can help avoid whipsaw.
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Sources:
– Michael C. Thomsett. “Getting Started in Stock Analysis, Illustrated Edition,” Page 245. John Wiley & Sons, 2015.
– Gregory L. Morris. “Investing With the Trend: A Rules-Based Approach to Money Management,” Page 369. John Wiley & Sons, Inc. 2014.
– Yahoo Finance. “Coinbase Global, Inc. (COIN).”
– Donald R. Chambers, Mark J. P. Anson, Keith H. Black, Hossein B. Kazemi, CAIA Association. “Alternative Investments: CAIA Level I,” Page 471. John Wiley & Sons, Inc. 2019.
– Robert Robbins. “Tactical Trend Trading: Strategies for Surviving and Thriving in Turbulent Markets,” Page 92. Apress, 2012.
Source: https://www.thebalancemoney.com/what-is-whipsaw-in-investing-5217006
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