Fakeouts, as the name suggests, is a breakout of an important technical level that fails to continue in the direction of the breakout. Trading fakeouts or, trading false breakouts, is another aggressive trading strategy.
Just because the market gets near a technical level that has not been broken for a while and then pushes through, doesn’t necessarily mean that the market is going to carry on in the direction of the breakout. Actually, the market is more prone to do false breakouts than genuine breakouts.
False breakouts are common and you could have easily fallen for them in the past. That’s what happens to most novice technical traders who are caught on the wrong side of the market.
How to Trade Fakeouts
Understanding how to trade false breakouts is easy once you grasp two crucial trading principles:
- We need clear support/resistance levels were we can look for false breakouts.
- Wait for the breakout candlestick closing price.
The breakout candle is the most important factor in deciding what is a false breakout and a true breakout. The first sign that we are watching a false breakout develop, is if we fail to close above the resistance level or below the support level.
If you want to have consistency and a higher win rate in trading fakeouts, then trading false breakouts in the opposite direction to the dominant trend can be your receipt for success.
- In an uptrend wait for pullbacks into support and wait for a false breakout to occur at this support level.
- Inversely, if we’re in a bearish trend wait for a retracement into resistance level, and hold back until a fakeout around this level occurs.
It’s also important that you only trade fakeouts at obvious and proven support and resistance levels.
The best entry strategy that you can use when trading false breakouts is to enter right after the breakout candle closing price. The advantage of this entry technique is that it will give you a tight stop loss while the potential profits can be exponentially larger.
You can literally trade false breakouts not just off of support and resistance levels, but against any other technical levels or price action patterns.
Another common technical tool that is prone to false breakouts is the trendline. In the example below, the USD/JPY bearish trend can be contained inside a downward trendline that at one point gets broken. The prevailing trend seems more powerful and the trend resumes to the downside. The moment we close back below the trendline that’s a good entry signal if you want to ride the trend.
When you see a fakeout move against the prevailing trend like the one in the USD/JPY chart above, it’s a good signal that the prevailing trend is about to resume.
Trading fakeouts are more suitable for short-term to medium-term trading even though false breakouts can also be found at the beginning of a new major trend.
Fakeouts can happen in all types of market conditions (trading, consolidation, reversing) and it can be a valuable tool that can signal possible changes in the trend direction or confirm the trend. Identifying fakeouts can offer good trading opportunities if you have a good strategy to attack them with.
If you’re able to identify clear support and resistance level and have the patience to wait for the market to produce a false breakout you can succeed with this strategy. The critical thing is to be able to identify the key elements prior to the false breakout and take full advantage of the opportunity to profit while limiting your risk effectively.