Even the people with a basic understanding of the stock markets understand that markets can be occasionally volatile. Researchers and analysts have formulated various tools and strategies to cope with the volatility of the market. Using advanced analytical and charting tools does help in predicting the movement of the market. However, no tool is perfect and markets are too complex for exact predictions. Sometimes, share prices move in the opposite direction when you least expect them to. When the change in the direction of the price movement happens suddenly, it is known as a whipsaw.
What is whipsaw?
Have you ever seen a lumberjack chopping a tree? If not, go to any video streaming app and search for lumberjack videos. They push and pull a saw in a continuous action to fell trees. The movement of the saw in opposite directions cuts the tree. The term whipsaw in the stock market has been derived from the action of the lumberjacks. A trader is said to be whipsawed if the price of security abruptly moves in a direction opposite to his/her expectations. Whipsaw patterns are often observed in extremely volatile markets. Day traders and short-term traders are often whipsawed when the market direction suddenly reverses. People with a long investment horizon are the least affected from whipsaw patterns as short-term volatility doesn’t have an impact on long-term returns.
Let us understand what does whipsaw mean with an example. Suppose the share price of XYZ is rising. You take long positions expecting the price to inch up. However, suddenly the momentum reverses and the price starts falling. The sudden reversal will either result in a partial loss or a complete loss of your investment. Similarly, one can get whiplashed even in the case of shorting. If you short the shares of XYZ and the price suddenly starts rising, you will suffer a loss.
Can whipsaw be avoided?
Whipsaw is the sudden change in the direction of the price of a security. To avoid whipsaw, one has to predict the sudden change in the prevailing trend in an asset’s price. Since price trends change suddenly in the case of whipsaw, it is easier said than done. However, one can take certain safeguards to avoid getting trapped in a whipsaw pattern. Conduct thorough technical and fundamental analysis before taking fresh positions. Analysis reveals if a stock is in the overbought or the oversold territory. Overbought stocks may witness an abrupt decline in prices and vice versa. To avoid whipsaw, be cautious while taking long positions in overbought stocks and short positions in oversold securities.
How to avoid whipsaw in stock markets?
Before trading in a new market or stocks, conduct deep research and analysis of the market and formulate a precise trading plan. A few steps can be taken by new traders to avoid whipsaw in stock markets.
Start with demo trading: When trading in a new market, it is advisable to start with a demo trading account. One can formulate new strategies and carry out an independent analysis to understand the trend of a specific market or security. Demo trading accounts use virtual money but offer the experience of actual trading.
Learn advanced analysis: If you are planning to start intraday trading or often trade in a volatile market, having advanced knowledge of technical and fundamental analysis can come in handy. Fundamental analysis will provide a broader view of the supply and demand scenario and other metrics that influence the share price. Technical indicators like exponential moving average and standard deviation can help you spot overbought or oversold assets and make an informed decision.
Use stop loss: Do not forget to set a stop-loss limit while trading in a volatile market. A stop-loss may not help you avoid losses, but will limit the losses to a large extent in the event of a whipsaw pattern.
A correct and in-depth reading of the technical and fundamental indicators can help you predict a potential whipsaw pattern in advance and trade accordingly. However, no strategy is foolproof against whipsaw in stock markets as whipsaw patterns are an abrupt development.