The "Shake-out"

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If there's anything you can count on in investing, it's that things don't always go smoothly. A stock will not always carve out a quiet, controlled uptrend. But some turbulence isn't all that bad, either. A shake-out can serve stocks well. It's generally a sharp sell-off that causes scared investors to dump their positions. This could involve a wild one-day swing caused by an analyst downgrade, company-specific news or economic reports. Sometimes a shakeout occurs in the absence of news. Regardless of the reason, a high-quality market will snap right back.

A shakeout can come in several varieties. A market could be forming a handle, where there is a day of wild action in heavy turnover. But as long as quiet, constructive action returns, one day of bad action isn't detrimental. Other times, a shakeout involves a more prolonged downturn and subsequent comeback that takes place over several days or weeks. Tests of the 50-day moving average (or 10-period moving average on a weekly chart) can also be shakeouts. If the market falls to the line or breaches it, but then snaps right back, that could become a buy setup, especially if it's accompanied by big volume. The second low in a double-bottom base is all about the shakeout. That's why it should undercut the first low. 

The Psychological Impact

Psychologically, shakeouts can be hard to deal with. The stock just caused an investor to face a loss or see paper gains vanish. It's human nature to want to back away and not go through the same pain. But at the same time, a shakeout can represent a buying opportunity. For example if a widely recognised support level has been breached stops may be triggered, sending a flood of sell orders into the market. Everyone takes fright while the market professional steps forward, buying the correction. Selling dries up when the stops are filled and the stock soon recovers back into its normal trading range. Everything returns to normal and the market professional now has a sizeable parcel of stock.

Trading The Shake-out

Generally the shake-out allows traders to buy into weakness.  Have you heard that before?  Buying weakness?  To some, it's their 'golden rule'. There are many ways to trade weakness and we won't go into all of them, but let's look at a couple of scenario's below.  

The Shakeout
GOL - The Double Bottom Shake-out Example

The Double Bottom Scenario - On Oct. 5, 2005, Gol Intelligent Airlines (GOL) tumbled as much as 11% intra-day, breaching its September low of 30.26 and thus creating what would eventually become a double-bottom (1). The stock cut its loss to 2% that day after demand came back into the market and broke out of the double bottoms resistance seven days later (2), with increased volume (4) - This could have been the buying opportunity. After a handle formed, a second breakout on Nov. 1 offered a second entry (3). Further reading on trading the shake-out this way can be acquired at our double top/bottom lesson in Mod 2.

The Swing Trap Scenario - A Swing Trap is a chart pattern that traps momentum traders causing a cluster of stop loss orders to be taken out. This offers a great opportunity for swing traders to hop on board a fast moving stock.

The example below is on the daily chart, but you will see this pattern show up on intra-day, weekly, monthly charts as well. In other words, it can be seem in all time frames.

The Shake-out
EZPW - The Shake-out Swing Example

Momentum traders tend to buy stocks near the 10 period moving average. This stock pulled back near that moving average and then moved up the next day (1). This bull candle confirmation can create buy opportunities. These momentum traders sometimes put their stop loss order underneath pivot lows (not shown here). So, when this stock moved below that level, many traders either sold or got stopped out. The key to trading this pattern is to wait for the "shake-out" - wait until all the sell and stop orders have been executed. The second pullback has to go below the pivot low of the first pullback. Once the majority of sellers are taken out of the stock, buyers will likely come in and the stock will rally. You'll also see this pattern on the short side - just reverse. 

To Sum Up

The market doesn't care what causes the "shake-out" and once the psychological shock has been overcome, many trading opportunities can arise from this market action. The above trading examples are obviously simplified for clarity and other technical analysis should be employed when making these trades and forming your own trading strategies. As we always say, technical analysis is not an exact science and although it can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

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If there's anything you can count on in investing, it's that things don't always go smoothly. A stock will not always carve out a quiet, controlled uptrend. But some turbulence isn't all that bad, either. A shake-out can serve stocks well. It's generally a sharp sell-off that causes scared investors to dump their positions. This could involve a wild one-day swing caused by an analyst downgrade, company-specific news or economic reports. Sometimes a shakeout occurs in the absence of news. Regardless of the reason, a high-quality market will snap right back.

A shakeout can come in several varieties. A market could be forming a handle, where there is a day of wild action in heavy turnover. But as long as quiet, constructive action returns, one day of bad action isn't detrimental. Other times, a shakeout involves a more prolonged downturn and subsequent comeback that takes place over several days or weeks. Tests of the 50-day moving average (or 10-period moving average on a weekly chart) can also be shakeouts. If the market falls to the line or breaches it, but then snaps right back, that could become a buy setup, especially if it's accompanied by big volume. The second low in a double-bottom base is all about the shakeout. That's why it should undercut the first low. 

The Psychological Impact

Psychologically, shakeouts can be hard to deal with. The stock just caused an investor to face a loss or see paper gains vanish. It's human nature to want to back away and not go through the same pain. But at the same time, a shakeout can represent a buying opportunity. For example if a widely recognised support level has been breached stops may be triggered, sending a flood of sell orders into the market. Everyone takes fright while the market professional steps forward, buying the correction. Selling dries up when the stops are filled and the stock soon recovers back into its normal trading range. Everything returns to normal and the market professional now has a sizeable parcel of stock.

Trading The Shake-out

Generally the shake-out allows traders to buy into weakness.  Have you heard that before?  Buying weakness?  To some, it's their 'golden rule'. There are many ways to trade weakness and we won't go into all of them, but let's look at a couple of scenario's below.  

The Shakeout
GOL - The Double Bottom Shake-out Example

The Double Bottom Scenario - On Oct. 5, 2005, Gol Intelligent Airlines (GOL) tumbled as much as 11% intra-day, breaching its September low of 30.26 and thus creating what would eventually become a double-bottom (1). The stock cut its loss to 2% that day after demand came back into the market and broke out of the double bottoms resistance seven days later (2), with increased volume (4) - This could have been the buying opportunity. After a handle formed, a second breakout on Nov. 1 offered a second entry (3). Further reading on trading the shake-out this way can be acquired at our double top/bottom lesson in Mod 2.

The Swing Trap Scenario - A Swing Trap is a chart pattern that traps momentum traders causing a cluster of stop loss orders to be taken out. This offers a great opportunity for swing traders to hop on board a fast moving stock.

The example below is on the daily chart, but you will see this pattern show up on intra-day, weekly, monthly charts as well. In other words, it can be seem in all time frames.

The Shake-out
EZPW - The Shake-out Swing Example

Momentum traders tend to buy stocks near the 10 period moving average. This stock pulled back near that moving average and then moved up the next day (1). This bull candle confirmation can create buy opportunities. These momentum traders sometimes put their stop loss order underneath pivot lows (not shown here). So, when this stock moved below that level, many traders either sold or got stopped out. The key to trading this pattern is to wait for the "shake-out" - wait until all the sell and stop orders have been executed. The second pullback has to go below the pivot low of the first pullback. Once the majority of sellers are taken out of the stock, buyers will likely come in and the stock will rally. You'll also see this pattern on the short side - just reverse. 

To Sum Up

The market doesn't care what causes the "shake-out" and once the psychological shock has been overcome, many trading opportunities can arise from this market action. The above trading examples are obviously simplified for clarity and other technical analysis should be employed when making these trades and forming your own trading strategies. As we always say, technical analysis is not an exact science and although it can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

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