In trading, one of the most frustrating events for beginners is encountering a fakeout. A fakeout occurs when the price appears to break through a key support or resistance level, only to reverse back in the opposite direction shortly after. Fakeouts can cause traders to enter positions too early, leading to losses. However, if identified correctly, fakeouts can also provide profitable trading opportunities. Learning how to recognize and trade fakeouts can give you an edge in the markets.
In this guide, we’ll explain what fakeouts are, how to identify them, and strategies for trading fakeouts successfully.
What Is a Fakeout in Trading?
A fakeout is when the price temporarily breaks through a key level, such as support, resistance, or a trendline, but then quickly reverses direction. It tricks traders into thinking that the breakout is real, causing them to enter trades that quickly become unprofitable. Fakeouts are common in volatile markets where price fluctuations are frequent.
For example, if the price breaks above a resistance level, traders may interpret this as the start of an uptrend. But if the price soon falls back below the resistance level, it’s a fakeout.
Why Do Fakeouts Happen?
Fakeouts occur because of a combination of market forces, such as large institutional traders and unpredictable retail traders. Price levels like support and resistance attract the attention of many traders. As the price nears these levels, it often triggers stop orders, leading to temporary price surges that create false breakouts.
Here are a few reasons why fakeouts happen:
- Liquidity Grabs: Larger traders may trigger fakeouts to drive the price in a certain direction to fill their orders at better prices.
- Market Manipulation: Some large traders attempt to push prices through levels, only to reverse them after other traders are trapped.
- Psychological Factors: Many traders rush into trades when a breakout seems to be occurring, but they may exit when the price reverses quickly.
How to Identify Fakeouts
Recognizing a fakeout early can help you avoid falling into traps and potentially profit from the situation. Here are key methods to help you identify fakeouts:
Volume Analysis
Volume plays a crucial role in confirming or debunking a breakout. When a real breakout occurs, it is usually accompanied by a significant increase in trading volume. If the volume is low during a breakout, it may indicate a lack of conviction, suggesting a potential fakeout.
- Low Volume: A breakout with low volume is often a fakeout.
- High Volume: A genuine breakout is usually supported by high volume.
Candle Patterns
Certain candlestick patterns can provide clues about fakeouts. Reversal patterns like the Doji or Engulfing patterns signal market indecision or a potential reversal after a breakout.
- Doji: This pattern shows indecision and can indicate a reversal is coming.
- Engulfing Patterns: Bearish engulfing patterns at resistance or bullish engulfing patterns at support are signs of a fakeout.
Time Frame Analysis
Fakeouts are more common on shorter time frames because the price fluctuates more frequently. To avoid being caught in a fakeout, use multiple time frames for confirmation.
- Shorter Time Frames: More prone to fakeouts due to rapid price changes.
- Longer Time Frames: Offer a more reliable perspective on the trend and breakout.
How to Trade Fakeouts?
Once you’ve identified a potential fakeout, there are several strategies you can use to trade it. Below are some methods for capitalizing on fakeouts:
Wait for Confirmation
One of the simplest strategies for avoiding fakeouts is to wait for confirmation of the breakout before entering a trade. Rather than entering the trade as soon as the price breaks through support or resistance, wait for the price to close above or below the level on the time frame you’re trading.
- Close Confirmation: Wait for a strong close above resistance or below support to confirm a breakout.
- Pullback Strategy: Wait for the price to pull back to the broken level and confirm the breakout before entering a trade.
Trade the Reversal
Another way to trade fakeouts is to trade in the direction of the reversal. Once it becomes clear that the breakout was false, you can enter a trade in the opposite direction to take advantage of the price reversal.
For example, if a price breaks above resistance but quickly reverses below it, you can enter a short position, expecting the price to continue falling.
Use Stop-Loss Orders
In fakeouts, it’s crucial to protect yourself by using stop-loss orders. A well-placed stop loss can limit your losses if the market reverses against your trade. When trading fakeouts, place stop-loss orders beyond the key level you’re trading to ensure you’re not stopped out prematurely.
- Tight Stop-Losses: Use tight stops to limit risk in case of real breakouts.
- Wide Stop-Losses: Consider wider stop-losses for volatile markets prone to sudden reversals.
List of Key Fakeout Trading Indicators
Several technical indicators can help you confirm or debunk breakouts and detect fakeouts:
- Volume Indicators: Tools like the On-Balance-Volume (OBV) or Volume Oscillator can help gauge whether a breakout is supported by significant trading volume.
- Moving Averages: Use moving averages, such as the 50-day or 200-day moving averages, to identify whether the breakout aligns with the trend. A breakout against the moving average trend may indicate a fakeout.
- RSI (Relative Strength Index): RSI measures the strength of a price movement. If a breakout occurs but the RSI shows overbought or oversold conditions, it may indicate a fakeout.
- Bollinger Bands: These bands help identify volatility. If the price breaks through the upper or lower bands but quickly returns inside, it could be a fakeout.
Benefits of Trading Fakeouts
Trading fakeouts can be highly rewarding when done correctly. Here are some benefits of mastering this strategy:
- High Reward Potential: Fakeouts often lead to sharp reversals, providing opportunities for high-reward trades.
- More Trading Opportunities: Fakeouts occur regularly in volatile markets, offering multiple chances to profit.
- Improved Risk Management: By identifying fakeouts, you can avoid entering false breakouts, improving your overall risk management.
Common Mistakes When Trading Fakeouts
Trading fakeouts successfully requires avoiding common pitfalls. Here are some mistakes to watch out for:
- Entering Too Early: A common mistake is entering a trade as soon as the price breaks through support or resistance. Wait for confirmation to reduce the risk of being caught in a fakeout.
- Ignoring Volume: Failing to consider volume during breakouts can lead to trading fakeouts. Always check whether the breakout is supported by significant volume.
- Neglecting Risk Management: Fakeouts can be volatile, so always use stop-losses to limit potential losses.
Example of Trading a Fakeout
Let’s walk through an example of trading a fakeout in the forex market:
Suppose you’re trading the EUR/USD currency pair, and it’s approaching a key resistance level at 1.2200. The price breaks above this level, signaling a potential breakout. However, you notice that the breakout is happening on low volume, and the RSI is showing overbought conditions.
Instead of entering a long trade immediately, you decide to wait for confirmation. The price quickly reverses back below the resistance level, confirming that the breakout was a fakeout. You enter a short trade, expecting the price to continue falling, and place a stop-loss just above the resistance level.
Over the next few hours, the price drops significantly, and you exit the trade for a profit.
This example demonstrates how waiting for confirmation and using technical indicators can help you trade fakeouts more effectively.
List of Key Fakeout Trading Tips
Here are some practical tips for trading fakeouts successfully:
- Use Multiple Time Frames: Check for confirmation across multiple time frames to avoid being caught in a fakeout on lower time frames.
- Wait for Close Confirmation: Avoid entering trades based on breakouts alone. Wait for the price to close above or below the key level before entering.
- Watch for Divergence: Use indicators like RSI or MACD to spot divergence between price action and momentum, which can signal a fakeout.
Conclusion
Trading fakeouts can be challenging for beginners, but with the right strategy and tools, you can turn fakeouts into profitable opportunities. By understanding why fakeouts happen, how to identify them, and what strategies to use, you can improve your trading performance and avoid getting trapped by false breakouts.
Remember to always wait for confirmation, use stop-loss orders, and combine your analysis with key technical indicators to trade fakeouts successfully. As you gain more experience and refine your strategy, you’ll be better equipped to spot fakeouts and profit from these market movements.