In Foreign Exchange trade a whipsaw means a condition of extreme market volatility, when rapid growth of a price is followed by a drastic fall (or vice versa). The origins of term are derived from the push and pull action used by lumberjacks to cut wood with a type of saw with the same name.
Quick changes of market environment put a lot of stress on investors – the wider the variations in an investment’s price makes it harder emotionally to not worry. Higher volatility also means that an asset’s value can potentially be spread out over a larger range of values leading to higher risks. Experienced traders, who have already undergone through whipsawing, may feel right moment for profiting and leave the market on time. But for novice trader these unpredictable fluctuations may cause significant losses.
Phenomenon of a whipsaw happens when market’s processes go opposite to investors’ predictions. A trader, who builds investment strategy upon current price trend forecast and then faces contradictory market behavior, is called whipsawed.
During strong market fluctuations all regular information sources, indicators and technical tools give conflicting signals, leaving a trader solely with his experience and intuition. Nevertheless technical analysis should not be disregarded as it provides guidance on arising trends and dynamics of financial activity eventually allowing to understand what’s going on the market.
Certain indicators were specially developed for estimation of market volatility and adjustment of investment strategies to real trading conditions. For example, ATR – Average True Range – indicator, originally created by J. Welles Wilder Jr., is very useful in whipsaw situation. The range of trading is simply the difference between highest and lowest price within concerned time frame. It is calculated for each currency pair and smoothed by use of a Moving Average method. Lower ATR means lower volatility and a strategy involving a currency pair with high ATR rate must be tailored to fit its trading volatility.
It should be remembered that ATR does not give any information about trend’s movement or strength. It only measures volatility of a price. Experienced Forex traders use ATR to determine better stop-order positions, which conform actual market conditions. In a whipsaw situation difference between High and Low prices increases, leading to extended true range and increase in ATR values (relative graph goes up). In this case traders try to arrange their stop-order within wider range in order not to be thrown out of the trade due to accidental price fluctuations called noise.
Another valuable indicator is MACD (Moving Average Convergence-Divergence). Originally it’s visualized as two-line graph where full line (called MACD) and doted signal line represent two Exponentially Moving Averages calculated for short and long terms respectively. MACD line reacts to price changes faster than signal line and trade signals are generated according to the crossing of two lines. When MACD line is above signal line the market is bullish; when it’s below slow signal line – then it’s bearish.
This concept was developed in MACD histogram where not only shown if bulls or bears prevail on the market but their relative strength could also be evaluated. MACD fastest reaction to price movements makes it possible to use in whipsaw conditions – actually it’s one of the best instrument that a technical analysis provides for volatile market.
Sometimes whipsaw signals may be recognized through Moving Average calculated for all quotations, not for closing prices only. In this case smoothing will integrate all available data and overcome whipsaw effect in analysis. It’s possible to say that various price “filtration” methods are intended to reduce influence of market fluctuations and increase overall efficiency of technical analysis for building of solid investment strategies.