Learn more about why a whipsaw occurs and how it affects different trading strategies.
Definition and Examples of Whipsaw in Investing
A whipsaw in investing occurs when any asset price or indicator quickly moves in the opposite direction that it had been going. Whipsaws can occur in both rising as well as falling markets. Upmarket whipsaws: Upmarket whipsaws occur when a market or security, generally witnessing an upward movement in prices, experiences a sudden downtrend before resuming its upward trajectory. Downmarket whipsaws: When an indicator or security is declining, but suddenly reverses course to rise for a short while before continuing on its downward path, it’s called a downmarket whipsaw. When a stock moves sharply in one direction, and then sharply in another it is whipsawing. Though a whipsaw generally means the asset moves against the prevailing trend (so it increases during a downtrend or decreases during an uptrend), it is also used for assets that don’t have an established trend. Coinbase (COIN) is a good example of a stock that saw whipsaw trading even though there was no established trend. On its first day of trading, April 14, 2021, it debuted at $381, shot up past $429.54, and then sharply decreased, ending the day at $328.28. Those sharp increases and decreases were whipsaw moves. A trader gets whipsawed if they buy a security immediately before its price drops or sell a security right before its price jumps, leading to losses. So in the example above, if a trader had opened a position in COIN at $400, saw profits for a little while, and then had been stopped out by the drop to $328, the trader was whipsawed out of their position. Whipsaw losses are a common part of trading. The final example is with trading indicators. If a trader opens a position because an indicator showed one thing and the indicator immediately changes to show a sell signal, the trader was whipsawed.
How Whipsaw in Investing Works
Whipsaw often happens when a stock is either overbought or oversold. Trend traders buy stocks that have been going up and short stocks that have been going down. At times, too many traders pile into these stocks and they get “overheated”. Overbought stocks are ones that have too much buying demand and have traded above their fair value. Oversold is the opposite. Stocks that are overheated are at the risk of a whipsaw because the further away they move from fair value, the fewer traders there will be to keep up the buying or selling demand on shares. When there aren’t enough and traders start taking profits en masse, a whipsaw can happen. Stocks that are trending up but have an RSI in overbought territory could keep trending up, but they could also be due for a whipsaw to get back into normal territory. Evaluating what’s causing the recent surge in buying demand can determine whether you should wait for better RSI numbers.
What It Means For Individual Investors
Sudden price movements, especially unanticipated reversals can affect portfolios and make investors nervous. Here’s how a whipsaw effect impacts different popular trading strategies:
Trend Following
Trend following is the main strategy we discussed above. Trend followers can be whipsawed out of a position if they buy when the stock is overheated. Seasoned trend followers using technical indicators like RSI to determine whether its time to buy or sell positions.
Swing Trading
Swing traders use momentum indicators to ride momentum over a period of a few weeks. Whipsaw can hurt swing traders when they enter into a position at a bad time and the stock immediately whipsaws against them. Swing traders can use volume indicators to evaluate whether a potential trade candidate may be heading toward whipsaw movement.
Scalp Trading
Scalping is a type of daytrading where traders target a lot of small gains, quickly moving in and out of stocks. Whipsaw movement is the bread and butter for many scalpers. They wait for the whipsaw to happen and then jump into the stock after the sharp drop to pick up the move back up.
Long-Term Buy and Hold
Long-term investors shouldn’t care about whipsaw by definition. If their expected holding period in a stock can be as long as ten years, or even forever, short-term drops that are corrected in a few days, weeks, or months simply don’t matter.
