What is Whipsaw?

Whipsaw describes the movement of a Security when, at a given time, the price of the security moves 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 the price of a stock, which is then followed by a drastic downward movement causing the price of the stock to drop from its original position. The second type occurs when the price of a stock declines for a short period of time, then suddenly spikes to achieve a positive gain from the stock’s initial position.

Key points to remember

  • Whipsaw describes the movement of stocks in a volatile market when a stock’s price suddenly changes direction.
  • There is no set rule on how to handle seesaw movements in a volatile market because it is an unexpected movement.
  • Whipsaw in securities trading often leads to trading losses.
  • Day traders expect see-saw movements and often take long-term buy and hold positions to ride out price swings to avoid a loss.

Understanding Whipsaw

The origin of the term jigsaw is derived from the pushing and pulling action of loggers when cutting wood with a saw of the same name. A trader is considered to “punch” when the price of a security in which he has just invested suddenly moves in the opposite and unexpected direction.

Sawtooth patterns occur especially in a volatile market where price fluctuations are unpredictable. Day traders or other short-term investors are used to being broke. Those who have a long term, buy and keep investment approach can often overcome market volatility and come out with positive gains.

For example, when an investor goes long on a stock, the price is expected to rise over time. However, there are many occasions when an investor buys shares of a company at the peak of a stock market rally. The investor buys a stock at its peak assuming it will continue to show strong gains. Almost immediately after buying the shares, the company publishes a quarterly report which shakes investor confidence and drives down the value of the stock by more than 10%, without ever recovering. The investor holds the stock at a loss, with no possibility of selling the stock, which is effectively distorted.

Conversely, some investors, particularly those who short sale, may face a whipsaw at the bottom of a market. For example, an investor might anticipate a slowing economy and buy put options on the S&P 500. The investor profits if the market continues to fall. However, almost immediately after purchasing the put optionsthe 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 look for patterns that explain market trends so that an investor can select the right asset classes. A study by Sonam Srivastava and Ritabrata Bhattacharyya, entitled “Evaluating the Building Blocks of a Dynamically Adaptive Systematic Trading Strategy”, explains that stocks patterns vary due to fundamental changes in macroeconomic variables, policies or regulations.

The authors state that a trader should adapt his trading style to take advantage of different phases of 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 bullwhip refers to any price movement that goes in the opposite direction of a trader’s intended bet, often resulting in a loss or, if able, overcoming price swings to maintain the investment and even make a profit.

Real world example

On Dec. 6, 2018, CNBC reported that stocks were skewed by news of deteriorating U.S.-China trade relations and the possibility of an economic slowdown reaching investors. Expert opinions varied.

To overcome volatility, one expert recommended investors choose a long-term strategy that leverages their strengths and follow that strategy regardless of the saw moves. In terms of investing, another expert recommended investing in more stable sectors like healthcare and avoiding more volatile sectors like real estate. Most pundits were expecting significant short-term volatility, and one recommended taking a defensive stance. However, he also said a long-term portfolio based on the stock would win.

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