Breakout attempts often end up being nothing more than lies, feints by larger forces, luring small speculators into traps designed to let more nimble stock traders add positions at favorable prices. These larger traders are capitalized and equipped to rush buy or sell orders into a security, shaking out smaller traders, then turning around and taking the opposite side of that trade, profiting on both sides of the price movement.
This profiting on both sides—buying and selling just before breaking out and then shorting back soon afterward—is standard fare not just for floor traders, but also institutional traders. This can cause even more violent price action during a shakeout.
Knowing that, learning how to protect your capital and navigate through a potential minefield of shakeout attempts is critical to keep from being chewed up by bigger players.
Why shakeouts occur
Shakeouts can be financially frightening because price moves against you suddenly. This fear is by design. The general idea is that an insider who’s been accumulating a stock will throw a sizeable portion into the market and drown demand, thereby temporarily driving the price down. Likewise, that insider could be liquidating a position so they can jump in and buy a big block of shares to kickstart buying, pushing prices up to the point they can sell profitably into the rally.
Shakeouts, which are more prevalent in relatively thinner individual equity markets rather than indexes or commodities, are engineered to get you to exit your position or hit your stops. The payoff for the other traders is they can buy or sell at more favorable prices.
For a smart trader who understands the dynamic at play, however, shakeouts also can offer a smart way to enter a trend when others are too scared to act, or confused at what action to take. In other words, you don’t have to be the engineer of the shakeout to take advantage of it. You only have to recognize when it is at work. Fortunately, price and volume offer you some clues as to when this is happening.