Whipsaws and Fake-outs

By Riverman

 

Some of the most frustrating and costly market phenomena a trader is likely to see are whipsaws and fake-outs. Actually these are pretty much the same thing, with the difference that calling it a fake-out attributes a negative intention to the market, essentially accusing it of messing with your head. And a whipsaw or fake-out can indeed have a serious impact on your confidence in yourself and your trading system. If you spend your days looking for price break-outs and trends and instead you get a string of these nasty up-and-down spikes, you may wonder why you got into trading in the first place. The past couple weeks have been a vivid case-study in whipsaws and fake-outs, which is why they seemed like a good topic for today.

So what is a whipsaw/fake-out, exactly? It’s a point in the market where the price moves dramatically up or down, and in the early stages may look identical to the start of a new trend. Then, instead of continuing the trend or leveling off, it’ll suddenly dive back down (or up, in the case of a downward spike) to a price close to where it started. If you’ve watched forex charts for any length of time, they’ve almost certainly crossed your path. But if you’re new to the currency markets, or aren’t sure exactly how to spot one, here are a couple from the past week’s EUR/USD market.

choppy forex chart
What causes them? Well, almost by definition they are points when there is insufficient momentum in a particular direction to sustain a trend. Because market sentiment is ambivalent, divided fairly evenly between longs and shorts, the price is unable to continue its break-out and falls back to where it started. If you’ve placed your limit/take-profit orders at an optimistic price point in anticipation of a strong trend, you’re likely to find the whipsaw comes nowhere near them and lands you back within a few pips of your entry price, and a few pips poorer thanks to spread costs.

The most dangerous whipsaws include price spikes in both directions, which after convincing you to place a trade in the direction of the first spike, then turn around and take out your stop-losses with the second spike.

If we broaden the definition a little bit, stop-hunting could be considered a type of whipsaw that’s staged by a broker within their own trading platform with the specific goal of hitting their clients’ stop-loss orders. If you see a whipsaw on your broker’s charts but not on anyone else’s, chances are you got stop-hunted.

That’s not to say you can’t make money on a garden-variety whipsaw or fake-out; I have no idea if it’s possible during stop-hunting. If you’re good at identifying markets in which they’re likely to emerge (like the current one), you can adjust your trading strategy accordingly by placing your limit orders at levels closer to the entry price than you would in a trending market. You might also try combining these more modest limit orders with a tight trailing stop to help prevent all your profits evaporating when the price suddenly changes direction.

Or, if you’re like me and find whipsaws and fake-outs too nerve wracking, unpredictable, and costly to play with, you can work on filtering them out of your trading by avoiding market conditions when they occur. In my experience these tend to be in range-bound markets with low volatility and little notable economic news to fuel a true break-out. I’m sure someone out there is getting rich off these things, but it’s definitely not me!