The shakeout was a tactic often employed by trading pools. Harriman, in particular, favored the shakeout as a device for forcing traders to part with shares cheaply. His method was to first gather in all the ready supply within a trading range. The stock was held to a narrow range for weeks at a time so that traders became frustrated by the lack of action. Then one or more false downside breakouts were engineered to drive out weak holders who either had placed stops under the market or could be frightened off by a sign of weakness. His method, in short, was to wear them out, then scare them out.
By early December, there are still traders of GE sitting with losses. Their hope is to get out even, or at least to recover part of their losses by selling into a rally. Selling will dampen any rally, so before a tradable advance can begin, these weak sellers must be dislodged.
If the previous low at B is broken, nervous traders might conclude that another downwave is about to begin, that it is better to get out now rather than to wait for a rally which might not come. The more daring might even add to selling on the break by selling short.
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Downside shakeouts, sometimes referred to as "bear traps" are bullish setups because they are effective in reducing overhead supply. Overhead supply is created by sellers who take advantage of short-term rallies to unload. Overhead supply impedes the ability of a stock or an index to rally.
But bear traps radically alter that supply-demand dynamic. A bear trap forms when important support is broken. The break forces sellers overhead to sell the break instead of waiting for the next rally, washing out weak hands on sell stops. That forced selling reduces the number of shares now for sale at higher prices, thus weakening overhead supply. Once the trap closes, that is, once price rallies convincingly off the low, sold-out bulls and trapped shorts are forced again to act, but this time as buyers. These sellers-turned-buyers are joined by other buyers to produce solid rallies which often carry beyond established resistance.
Of course, there's a catch. You can't tell you've got a bear trap for sure until it closes, until there is a convincing rally off the lows.
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Up until now, indications have been very positive that strong hands are providing support for the stock. As GE breaks below support at B, we must be alert for the possibility of a shakeout. If the action at C through D turns out to be a shakeout, there is a good chance that the high of the trading range, at a price of about 12, will be breached to the upside.
At point D, volume rises to its highest level in weeks. The battle between frightened sellers and bargain-hunting buyers is heating up. The next period's action (E) shows that buyers have once again taken control. Volume on the rally at E is light. This should not be interpreted bearishly. Sellers have been squeezed out, and the stock is now "light". With little supply to impede the advance, moderate buying is enough to close the stock back above support at E (see support line).
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We recognize the downside breakout as a shakeout. Sellers and short-sellers have been trapped. We now have every reason to expect that a strong rally will close the trap quickly.
Knowing that buyers are now in control, we take an initial long position at 10 1/2. By buying so close to support, we limit our risk. Should our immediate expectations not pan out, we are ready to jettison our position quickly and take a small loss. But we also know that a successful shakeout can produce a good rally which has a chance of carrying well beyond resistance around twelve.
As expected, a rally challenges supply around 11 3/4. We note that volume increases at that point. Buyers are running into increased selling at that level, but price action remains positive. Our bet is that supply has been sufficiently reduced by the shakeout to allow a move above 12, so we maintain our initial long position. But supply is strong enough to repel a first attempt to break out, and the price reacts to F. We remain long, but alert.
Volume on the decline to F is light, a good sign. Sellers are not aggressively pursuing the price down. After the test at F, the stock rallies on moderate volume and widening spread. We are encouraged by this action, and now expect bidding to breach supply at 12.
However, the decline at G upsets our expectations. Support at F does not hold, and the decline on increased volume and widening spread convinces us that sellers have not yet been flushed from the stock.
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Based on our earlier analysis, we established a long position in the expectation that the stock would cut through supply at 12. The action at G offers evidence that resistance remains stiff. We suspect that more accumulation will be necessary before the stock is ready to rally. That might involve more dull trading and perhaps additional shakeouts in the attempt to dislodge stock from weak hands.
Buyers and sellers appear about even in strength. Betting on either side now is no better than a gamble. Our initial position was small, but we decide to close it out until the odds tilt more clearly in one direction or another.
It is important to note that the decision to close out the position is not based on the profitability of the trade, but only on our assessment of the technical condition of the stock and on our analysis of the odds of near-term success.
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After we take a neutral position at G, the stock begins a long, slow decline on moderate volume. Those traders still looking to get out of the stock have little to cheer. Disgusted and bored, traders exit all the way down. Few rallies interrupt the dull drift of the stock back to the lows registered on the selling climax, and again at D. These desultory conditions favor more patient, stronger hands. Stock is taken in on dips by strong hands, without the kind of aggressive bidding which might provide encouragement to weak sellers.
At H, the price again tests support. Spread compression on increased volume shows that buyers are providing support. A modest rally ensues, but there is little evidence that the stock is ready to mount a tradable rally.
Then the stock breaks long-term support at I, a move which we must consider carefully. If sellers are still around in size, this evidence of weakness could spark a new wave of selling. To guard against a downside breakout, longside traders have doubtless amassed considerable stop-loss orders just under support. If those stops are triggered, the stock could drop sharply--unless buyers are ready to hold the bag for more cheap stock.
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Price breaks support at I. Volume picks up and spread compresses--supply increases on the break, as expected, but offered shares are mopped up by stronger hands. The stock closes above support. This has all the signs of another shakeout, but one of considerable importance, given the importance of the support level being tested.
We decide to probe the long side by taking a small initial position at the opening on the next day. If the trade proves successful, we will add to our position; if not, we will again exit and await better conditions.
The stock rallies, then churns for two sessions on moderate volume. Price briefly returns to support, then closes higher during the following period. The high-low spread contracts considerably and volume drops away noticeably. The struggle for dominance at this level is over, and the noise of battle (volume) abruptly quiets. We conclude that the stock is set up to advance.
At J, we add to our initial long position. Should the stock fall again below support, we will exit at the market. This low in the range, our risk is small and quantifiable. On the other hand, GE has been accumulating for months, coiling for what could be a big advance. Risk vs reward is very favorable.