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Part III. Trading Fakeouts

Trading Fakeouts - Forex School
Commander in Pips: Now it’s time to pass to the fakeouts part of this discussion. If you remember, a “fake out” is also known as failed breakout. Dealing with fakeouts is as important as with a breakout or even more important. This is because fakeouts appear more often than breakouts, especially on intraday charts. In general, a fakeout happens when initially the market shows a breakout of some support/resistance line but then returns right back and shows a move in the opposite direction. This support/resistance line could be different – trend line, channel, Fib level, classical support/resistance or lines in different patterns, say, neckline in H&S.

A “fake out” is also known as failed breakout - Forex School

Now I want you to tell me what support and resistance levels are. Just to remember…

Pipruit: Support/resistance areas are areas where we expect predictable price response when it will touch it. Particularly speaking, support area has significant buyers’ pressure that could stop possible sellers’ action. Strong support areas even could hold if market will slightly break them, just by momentum. This slight breakout could be nice buy opportunity.

The same with resistance areas – sellers’ strength here increases significantly, so it could stop potential increase in purchases, i.e. buyers’ momentum. Strong resistance area also could be penetrated by market for a short-term, so this could give use am acceptable moment to enter short.

Why we should trade or deal with fakeouts? - Forex School

Commander in Pips: Right you are.

Pipruit: But commander, why we should trade or deal with fakeouts – maybe it’s better to skip them? And why they happen even more often than real breakouts?​

Commander in Pips: The answer on both of your questions is simple and it comes from a major market law. We’ve discussed it some times in different chapters of our school.

Once we’ve said that market has finite amount of money. There are two different sides on the market – winners and losers. Since winners make more money than they have had initially, they need some constant inflow of money. This is just where their profit comes from… Maybe you’ve heard some business news from time to time – such as on Bloomberg or on CNBC or other channels about profit of major world banks on currency markets. Don’t you think that they hold 70% of overall turnover accidentally?

Pipruit: I guess not. I think that I know about what you want to tell me…​

Commander in Pips: So, if this was a loss market – they do not deal with it, right? Hence – they are winners there. And how many of these are there? Not many, in fact they are few – 10 major banks and then, as we’ve said in the Forex structure, smaller and smaller banks and companies. But who provides all this money for their winnings?

Pipruit: Crowd…​

Commander in Pips: Right. 2-5% of participants win, while others 95-98% lose or provide money – that’s the same. You can imagine how many retail traders would be needed to guarantee big banks their profits…But how, and why? The difference stands in the way of trading and the predictability of crowd action. The difference also stands in public’s mentality.

Pipruit: Tell me more, Sir.​

Commander in Pips: Ok. Here’s an easy example:

Public (retail traders) mentality:

They treat any support and resistance levels as some kind of high and low or, as a ceiling and floor, if you want. They expect that if any breakout will happen – then further price action will continue in the direction of the breakout. If support level will break, then most traders will intend to sell, while if resistance is broken – most traders will start to open long positions. For the crowd the greed mentality is very common. The public believe in trading in a row with breakout. But not only in trading – they want a huge move, they want big money and big profit.

What comes next…

You may ask and what is the problem with it? Is it bad to hope for huge move? Nope. But switch on your brains – there is a big whale on the other side of your wire and he has to make his money, and shareholders will fire him at the end of the financial year if he loses. That is the imperfection of our world. As Metallica sings – “Sad but true”.

Imagine? Great. So, what will we have due to this imperfection? The truth is that most breakouts fail, just because the smart big guys have to make their money. They give you liquidity and it’s not really free of charge. Since you use it – you have to pay for it and the smart minority want to make money using the naïve majority. I think you understand me already…

Pipruit: Not quite…
Commander in Pips: Ok let’s go further. When he public anticipate breakout or start to prepare for it they want to buy above resistance (or to sell below support) and crowd is huge. Since whole crowd wants to buy, who will have to sell to fill their orders? The market maker will, since this is his duty – to provide liquidity. But he is not a fool. Where does the crowd usually place stops? Just below a resistance level. The market maker sees that.

…and finally

He fills all public buy orders by taking the other side of trades and selling them his position, then he adds a few more shorts to pressure the market down until the public’s stop buy orders and closes his shorts with those orders – Bingo! – we’ve got fake out! Of course, market makers don’t do that blindly. There are sharp calculations that depend on market depth, since if the market maker will open too many shorts when he pushes the market in the direction of public’s stops, he takes the risk not to be able close all of them in profit. Second, market makers see the larger picture. If market sentiment has changed, then a true breakout is possible and the market maker just fills public orders with hedging them. But in most cases, the public trades breakouts, while the smart minority – fade breakouts, i.e. trade fakeouts.

Pipruit: Very interesting and useful information. Thanks. But how we can be sure that this will be breakout or fake out?​

Commander in Pips: Well there could not be a 100% guaranty, but still we can follow some steps in different scenarios that could help us. First, remember what we’ve said previously about breakouts of support/resistance levels, trend lines, Fib levels etc. and about wash & rinse patterns.

Pipruit: Ok. I hope I’ll able to do that:​

1. First, there are rules in Chapter 8 about support and resistance where we discuss the Wash & Rinse pattern;

2. Chapter 10 is when we’ve discussed that the market could pierce levels, especially when it tends to be reaching for a Fib extension target;

3. Chapter 11 is about dynamic support and resistance;

4. Chapter 14 has examples of trading basic patterns – to catch the first signs and get into position in advance, so that to come to the crucial point, such as a neckline can be done calmly. Second is to be aware of strong Fib levels just outside the pattern, since the market could reach them and reverse right back leading to a failed breakout;

5. Chapter 18 is about divergences, since this signal could give an early hint on a possible breakout

6. And, finally the lesson of Chapter 20 – since volatility and market’s momentum could you tell whether we expect a true breakoout or not.

Commander in Pips: Great work! I hope you will reread that material. Still, today I want to show you some additional possibilities that will allow you to not be hurt by market action in fakeouts.

Let’s start from a simple trend line:

Chart #1 | 30 min EUR/USD
Here we see three fakeouts - Forex School

Here we see three fakeouts. Even you’ve adjusted trend line based on first failure breakout (dashed grey line), the second and third failure breakouts will happen. The nature of price movement develops so that price action comes off the line for some distance and then gravitates back to the trend line again, finds support there and then the cycle repeats again. This is the market’s breathing around a trend line. We have spoken about that already.

Since there is no absolute on the market, during such a gradual moving market, price could penetrate the trend line from time to time. You can use this penetration to fade breakouts and trade them.

One thing that you do not want to see is an explosive breakout out with just straight angle:

Chart #2 | 15 min EUR/USD
spikes or bearish engulfing patterns, doji etc. - Forex School

You want to see gradual move and preferably if market shows some long tales during breakout – spikes or bearish engulfing patterns, doji etc.

Pipruit: Ok, I understand – If market just explodes – it’s better to step aside and do not fade breakout, since momentum is strong. We rather want to see a gradual move during the trend, so that a fakeout becomes probable. It’s better to watch for them, since it’s preferable if the market forms some candlestick reversal pattern, or at least indecision. But, Commander, how do we step in – just enter in a row with the and hope that this will be a failure breakout?​

Commander in Pips: Of course not. We need some confirmation from the market. Take a look at chart #3. The safe way to enter is to wait for when the market returns back above trend line. Then we apply the 3-period rule and enter the market during next three periods. Since this is a mini reversal, because the market pushes back from trend line, usually there is some retracement taking place after that push and we use it for entering. The same could be done in case of a downtrend, but in the opposite direction, of course.

Chart #3 | 30 min EUR/USD
The safe way to enter is to wait for when the market returns back above trend line.- Forex School
Now let’s speak a bit more about reversal patterns – double top/bottom and head & shoulders, since they are most well-known. But this could be applied to any other pattern.

Market makers like reversal patterns, especially well-known ones, because the public is very predictable here. On the following chart you may see the typical thoughts of the crowd. Since they recognize the pattern, they put stop entry orders on breakout of the neckline and stop from the other side of the neckline:

Chart #4 | 60 min EUR/USD Double Top pattern
60 min EUR/USD Double Top pattern - Forex School

Market makers will tell you – “Thanks a lot!” See fast acceleration up after fakeout? That is a stop triggering that adds fuel to upward move.

Chart #5 | 60 min EUR/USD Double Top pattern failure with false breakout
60 min EUR/USD Double Top pattern failure with false breakout - Forex School
The same example with Head and Shoulders pattern on the hourly time frame:

Chart #6 | 60 min EUR/USD Head and Shoulders pattern
60 min EUR/USD Head and Shoulders pattern - Forex School

Chart #7 | 60 min EUR/USD Head and Shoulders pattern failure
60 min EUR/USD Head and Shoulders pattern failure - Forex School

Pipruit: So, what I will have to do if I want to possess myself to fade a breakout, or the opposite – to open a position in accordance with a chart pattern and to not be hurt by a fakeout?​

Commander in Pips: Let’s start from the first question – how to open a position to fade a breakout:

1. You have to check – are there any strong support areas (or resistance if this is reverse patterns) existing just below neckline? If there are, then the probability of breakout failure is significant and you may try to trade it.

2. Even if there are no such levels, you may keep a close eye on price action around breakout and look for some candlestick reversal patterns, butterflies opposed to the breakout or something like that. For instance, you may see that in the example with Double top market has formed nice bullish engulfing right after breakout:

3. Usually, if you intend to anticipate false breakout and fade it – you may enter in opposite the direction to the breakout with a stop below the low of the fakeout and target – near the top of the right shoulder or Double Top pattern. Although the risk to take the loss is high – the risk/reward ratio is also solid. 

Anyway, it is better to rely on some market’s clues that could appear on intraday charts that could hint of a false breakout.

On the second part of your question we have answered already. The major approach to trading classical patterns is to open your position prior reaching of the neckline, based on some clues and attention to nuances. Re-read chapter 14 for details. Second – adjust (reduce) your target if some strong levels stand just under the neckline. This allows you to make a little profit even if the market will show a breakout failure.

Pipruit: And is any market suitable for trading breakouts? I mean not particular asset but price behavior.​

Commander in Pips: Well, it’s better do in a relatively calm market that does not stand in a thrusting move. The perfect situation is if the market is ranging. This environment is the best for trading fakeouts, thinking in that direction you have to understand what trading session and week days are most suitable for that purpose….

But be careful. Any range-bound action will end sooner or later with some news release, market event, data release or something. How this could finish you may see on chart #8…

Chart #8 | 60 min EUR/USD ranging market with fakeouts
60 min EUR/USD ranging market with fakeouts - Forex School

Comments

pringy
7 years ago,
Registered user
Hi Sive,
Seasons greetings!

Just curious, you have not mentioned the use of any indicators to judge a breakout. E.g. ATR? Apart from using divergence.

Also, in terms of interpreting a good strong trend, what are your views of ATR vs ADX? Both seems to give quite different signals.

cheers
Sive Morten
7 years ago,
Registered user
Hi Pringy,
there will be a chapter, dedicated to volatility and applying such indicators as ATR, Historical Volatility and some others for estimation of possible reversal.
Application of ATR and MACD Hist is here:

https://www.forexpeacearmy.com/forex-books/140/chapter-20-part-ii-trading-breakouts

Concerning ATR and ADX, personally I do not use them. I prefer to use MACD and 3x3 DMA as thrust identification. While trend develops I keep and eye on MACD hist. to monitor overall momentum.
Besides, ATR and ADX work absolutely different, just take a look at their math. ATR has more common with historical volatility, although it is much simpler.
pringy
7 years ago,
Registered user
Thanks Sive - and I hope you did manage to have a bit of a christmas break! cheers
Hamza Samiullah
2 years ago,
Registered user
Long but simple lesson...
One-fm
10 months ago,
Registered user
Great lesson.

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