Stocks don’t always move up. Once in a while, corrections do happen on price moving up for an extended period. A strong reaction to uncertainty or bad news often causes investors to react strongly, resulting in steep pullbacks. A shakeout is a situation in which investors exit their positions or market segment at the same time.

A shakeout occurs when investors close positions on price, suffering a significant pullback. A long price decline often fuels fear in the market, causing many buyers to exit positions leading to a massive sell-off.

Upon buyers exiting the market, the lack of upward momentum causes prices to correct lower. In the stock market, a shakeout can occur whenever a leading stock corrects in price, fuelling concerns in the overall market.

The EZPW chart below shows that price was trending up before experiencing a steep sell-off at the $18.5 level, which was later followed by a massive rally following a shakeout. 

EZPW chart

In this case, the pullback can be strong and sharp in terms of amounts lost from record highs. The sharp sell-off can signal price has changed direction and likely to continue edging lower. Given that shakeouts occur during a period of market turmoil, it causes most investors to exit their positions on fear of increased sell-off that could see them losing much more if they continue holding on to too long positions.

However, with market shakeouts, strong pullbacks don’t always hold for long. In most cases, the price often reverses and starts moving higher after sellers are shaken out. The bounce back is usually strong resulting in price powering through the previous high, before the correction, due to more buyers flocking the market.

Shakeouts appear just before smart money begins streaming into the market as bulls try to bolster positions at highly discounted levels.

How Do Shakeouts Happen

Extended periods of rising prices often result in bears exiting the market-leading in price powering through resistance levels, conversely registering new higher highs. After moving up for an extended period, due to a lack of bears in the market, the price often experiences strong resistance. Strong resistance at the back of waning volumes many at times results in the exhaustion of the bullish momentum.

Failure to break through a strong resistance often halts price advance. If the strong resistance is followed by uncertainty in the market and a string of bad news, traders react by exiting their positions.

The lack of sufficient buying pressure to sustain price at current higher highs often results in price pulling lower. The pullback can be strong and vicious whenever short-sellers sense a window of opportunity to push prices lower from overbought conditions.

The pullback can go on for some time until the price hits a key support level. After hitting the support level, buyers who had missed out on the previous run higher leading to the shakeout, often use this opportunity to open a buy position at discounted levels.

Once the buying pressure builds up after the shakeout, a bounce back in price follows suit resulting in price powering high conversely reasserting the previous uptrend.

How to Trade Shakeouts

Shakeouts present ideal market conditions for swing traders to profit as momentum shifts in favor of bulls. Whenever shakeouts happen, they result in stop-loss orders being triggered, offering an opportunity for swing traders to board as prices edge lower on huge volume.

ACXM stock

In the chart above, ACXM stock was trending higher before price experienced strong resistance near the $12.7 level. Price pulled lower, breaking through the 10MA as bull’s exited positions. A lack of sufficient bearish pressure resulted in price moving up once again from point 1 only for buyers to exit positions as price struggled to break through the 10MA a key resistance level

Price ended up collapsing to the $11.5 level. However, the $11.5 level emerged as a strong support level. Once sellers were shaken out and buyers came into the fold, price edged higher, breaking through the $12.7 resistance level to a new high of $14.5.

The key to trading this pattern is to wait for a shakeout, and sellers withdraw from the market after a massive correction lower. The scion pulls back has to go through the previous pullback, followed by a bullish candlestick signaling that the price is about to correct higher.

Popular Industry Shakeouts

Shakeouts do occur most of the time, especially after a long bull run. The most recent market shakeout happened in the first quarter of 2020. In March, the stock market experienced a massive pullback from record highs at the time, as uncertainty over COVID-19 pandemic aroused fear, causing investors to exit positions and scamper for safety in safe-havens such as gold and the U.S dollar.

Shakeouts Stocks pulled lower, some touching one-year lows as others sold off to all-time lows. In the aftermath, the stock market bounced back, and stocks rallied, ending up recording new all-time highs following the market shakeout.

Shakeouts also did occur at the start of the new century, commonly referred to as the dotcom bubble as stocks imploded on buyers exiting positions on fear about the millennium. Later on, stocks bounce back, going on to register one of the most significant bull runs.

The 2008 financial crisis, later on, triggered one of the biggest market shakeouts in recent history as stocks and all the major indices tumbled as fears about the economic recession gripped the market. It took almost two years for stocks to start edging higher after billions of dollars were pumped in stimulus packages. Beginning in 2010, stocks registered one of the biggest Bull Run as the global economic situation improved.

Bottom Line

Shakeouts are a common phenomenon in the stock market after price moves higher for an extended period. Often, the price hits a strong resistance followed by a series of turmoil and uncertainty that fuels fears resulting in buyers exiting positions.

Price would often tank to a key support level from where sellers are shaken out as smart money starts streaming in as value investors jostle for positions at discounted levels. The result is usually a spike in price past the initial resistance level to new higher highs.