This week I thought we could look at the VSA principle of the shakeout.
A shakeout is defined as a violent test for supply, where price quickly pushes lower with a relatively wide spread, catching stops, and challenging any sellers to come out, before recovering to close back in the top half of the bar (usually right up near the top of the bar).
When a shakeout occurs it usually causes quite a bit of havoc in the market, causing angst among existing holders, and even panicking some shorter term traders into selling. Weak holders will often sell as price falls (or their stops are hit), this removes potential sellers before price moves higher at some point in the future (these sellers may thwart a price mark up, by selling into the coming rally).
A successful shakeout is a sign of potential strength, and is designed (or engineered) to remove and absorb supply, prior to price moving higher. A shakeout usually dips below an obvious previous support level, which is often a piece of structure where stops are placed.
Shakeouts work best with strength (strong buying) in the background, or with price already in an uptrend, and work worst with selling in the background or when price is already in a downtrend.
Shakeouts can, and do, fail.......they are not a guarantee of a future move higher.
The shakeout is often used within a sideways range, particularly in an accumulation zone, or re-accumulation zone, as part of the process to remove supply before a breakout. They are not so common in a distribution zone, so their presence can be use to help define the intention behind a sideways range.
When price dips lower in the early stage of the shakeout, if the volume drawn out is low, it suggests selling pressure is low, and price maybe close to a push higher, or a breakout. When price draws out relatively high volume, the fact it closes up high on the bar (if it didn't it wouldn't be a shakeout), suggests that demand is strong, and the supply has been absorbed. However, when high volume is drawn out - particularly in a sideways range - that level will probably be revisited again in the future, as if high volume is present price will rarely move much higher (because they are potential sellers into a future rally being drawn out).
The chart below sees price in a downtrend, which then morphs into a potential accumulation zone.
As is common, it begins with some form of climactic action, then price moves sideways, which is an attempt to remove supply as the accumulation process begins.
The initial shakeout (marked) occurs fairly early on, and draws out some increased (but not excessive) volume.
Price then continues sideways as the accumulation process continues, until a second and more violent (deeper) shakeout occurs.
Note that this shakeout draws out considerably lower volume (when compared to the first), and in hindsight was the end of the sideways range. In hindsight this would be called a terminal or final shakeout, although that would not have been know for sure at the time (there may have been some speculation after it only drew out low volume). If this second shakeout had drawn out relatively high volume again, I expect the accumulation process would have continued for longer, until a point was reached where volume (selling pressure) is low. Remember an accumulation zone is not to just to buy stock, it is also to remove holders who will be potential sellers into a future rally. As the supply from these sellers will likely have to be bought at some point when the mark up begins (at a higher price), so it is better to remove them at a cheaper price now, when possible.
Finally, notice the little low volume test just prior to price breaking out, and then the gap over the highs of the sideways range to begin the breakout. A gap up in this position is a really common tactic, by using the greed emotion, to encourage any potential sellers to hold on for longer, and potentially make more money (and not thwart the breakout and future mark up).
In the chart below there are two breakouts marked.
The first is after an initial breakout and is a two bar shakeout (merge the two bars together, and use the latter close).
The second is after a secondary breakout.
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Below price is in an uptrend.
When shakeouts occur they almost always dip below an obvious previous support level, which can be seen in both these shakeouts.
Shakeouts can occur in any timeframe (from very short intraday charts, to monthly or longer charts).
The second on this chart is a weekly shakeout, but shown on a daily timeframe.
(on the weekly chart it would just be a normal one bar shakeout).
If those five bars are all merged together, and the final close is used, you can picture the shakeout.
Sometimes it is handy to be able to picture a longer timeframe while watching a shorter one, instead of flipping between them.
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Below is an attempted shakeout in a downtrend.
As can be seen, price rises for one bar, before the negative influence of the downtrend takes over, and forces price lower.
Hopefully this helped your understanding of shakeouts.
