What is whipsaw in trading and how does it work?

What is whipsaw in trading?

Whipsaw in trading describes a sharp increase or decrease in an asset’s price, which goes against the prevailing trend. Whipsaw is different to other reversals because it is characterised by a sudden change in an asset’s momentum shortly after a trader has opened their position.

Whipsaw example

As a whipsaw example, let’s suppose that you’ve just opened a long position on the FTSE 100 because the price has been rising consistently. It continues to rise after you open, but all of a sudden the index begins to fall. Since you’ve gone long on the expectation that its price will rise, this will mean that you either lose a proportion of your profits, or you could incur a loss outright.

Learn how to trade the FTSE 100

Alternatively, if you had a short position on the FTSE 100, you’d experience whipsaw if the index’s price suddenly started to rise. Again, this would need to happen shortly after you open the position for it to be considered a whipsaw rather than a standard reversal, and you’d lose profits or incur a loss if the price kept rising.

How to identify the whipsaw effect

To identify the whipsaw effect, watch out for a sudden change in an asset’s price against the prevailing trend. This is hard to identify before it has happened, but there are some things that you can do.

For example, you can carry out analysis – both technical and fundamental – before you open a position to determine whether an asset is currently overbought or oversold. Overbought assets could experience a sudden decline in price, while oversold assets could experience a sudden increase in price.

When an asset is overbought, you might experience whipsaw when going long. If it is oversold, you might experience whipsaw when going short.

How to avoid whipsaw in trading

To avoid whipsaw in trading, research the market you want to trade, carry out analysis, and create a trading plan. You should also set stop-losses when opening positions. These will cap your losses if you are caught out by whipsaw.

Learn more about creating a trading plan

A good way to practise avoiding whipsaw is by using a demo trading account – a risk-free environment that you can use to trade new markets and test new strategies. Since you’ll be trading with virtual funds, no real money is ever at stake when trading on a demo.

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Both trading on a demo account and trading the live markets can be enhanced through carrying out your own technical and fundamental analysis – which can help you identify overbought or oversold assets.

Popular technical indicators that can help you to identify overbought or oversold assets are Bollinger Bands, standard deviations and the exponential moving average. You can also use channel indicators to track an asset’s volatility, with more volatile assets that are towards the top band of their historical price action being more likely to experience a reversal.

Learn more about technical analysis

Alternatively, you could look at fundamental factors such as supply and demand in the underlying market – which is useful for assets like oil and other commodities. High supply but low demand might indicate that an asset’s price will fall, while low supply but high demand might indicate the opposite.

Or, you could also look at other fundamental metrics like the price-to-earnings ratio when analysing stocks and companies.

Learn more about fundamental analysis

Whipsaw in trading summed up

• Whipsaw in trading is characterised by a sharp and sudden reversal in the prevailing momentum shortly after a trader opens their position
• When a trader goes long, the price will need to suddenly fall for it to be considered whipsaw
• When a trader goes short, the price will need to suddenly rise for it to be considered whipsaw
• Identifying when an asset is over- or under-bought can help you to avoid whipsaw in trading
• You can identify these levels by carrying out analysis on an asset before opening a position