Imagine the following scenario.
You’re watching the US dollar index in your MT4 platform, and have been doing so for weeks. Poised and waiting for the big break above a key resistance level so you can take advantage of the rip that you think is sure to occur.
So a couple of weeks of zen-buddhist like patience and unwavering discipline, that DXY (or the US dollar index) spike hits and that resistance level is, shall we say, futile.
It’s finally time!
You pop your position size in, set your order and hit ‘trade’. Before you hit they hay for the day you check out your levels once more and then call it a night.
The next day you get up with enthusiasm to check out the progress of your DXY trade only to find that that former resistance (now support) has failed miserably. And not only that but it retraced strongly and took out everything that stood in its way… including your stop loss.
DXY ends up closing the day well below the breakout level, completely negating your trade, not to mention your bullish bias.
Does this scenario ring any bells?
I’m sure it does. We’ve all been there and will without fail end up there again at some point or another. The fact is, even the best looking setups can and will fail on occasion.
Naturally, you have to ask yourself, why did it happen?
More importantly than the why, ask yourself how you could have mitigated the risk or perhaps even profited from the fake break.
Well punters, that’s what we’ll try and learn today. Hopefully by the end of this post you’ll have a fair idea of what false breaks are and how you can trade them.
What’s a Fake break, or Fakeout?
A fake break, or Fakeout is when price moves above or below our breakout levels, then reverses and fails to respect the recently broken level as either support or resistance.
Let’s check out an example now.
Notice how the DXY closed above our breakout level, but subsequently failed to hold above the area as a new support zone.
Now, as I always harp on about, we’re trading closing prices, so if the candle only pierces our breakout area, it’s an invalid break.
Trading false breakouts
Ok, so you know what a fakeout is. So let’s check out how they can be traded.
Just like the our pinbar strategy [https://www.vantagefx.com/education/a-better-way-to-trade-pin-bars/], a breakout that doesn’t follow through is without a doubt a sign of prevailing weakness, and just like any other price action signal, we can use this to our advantage.
Let’s have a look at how we could have used our DXY example and traded it on the short side after it stopped us out of our long breakout/fakeout. To do that, let’s drop down a time frame to see if there are any solid reversal candles on offer.
You can see on the above image of the smaller timeframe on MetaTrader 4 that after our breakout turned around and nailed our stop, we were presented with two candles that showed hesitation in moving any higher. These candles were both valid entries by offering a great R:R trade.
Let’s wrap it up
When trading fakeouts, it’s important to remember that all trade ideas are based on probabilities, not guarantees. So, as a fake break of a significant level can often result in a move in the opposite direction, it does not every guarantee that it will do so.
I always think that trading fakeouts can be a risky manoeuvre when going against the prevailing trend, however they’re still a perfectly valid tool to have up your sleeve when used with patience and poise.
Source: Vantage FX Blog