How to Trade the Fakeout

30 ago 2023

Welcome to our Power Patterns series in which we teach you how to trade some of the most powerful price patterns which occur on any timeframe in every market.

This week’s pattern, the fakeout is beautifully simple and has the power to be highly effective. It has stood the test of time and should be a key part of any price action traders arsenal.

We’ll teach you:

• Why the pattern is so powerful
  
• How to identify and anticipate the pattern
  
• Three simple rules that can supercharge the patterns effectiveness
  

I. Understanding the fakeout:

The term ‘fakeout’ is trading slang for false breakout, the fakeout pattern occurs when a breakout fails at a key horizontal level in the market.

We’ll be focusing on the single bar fakeout which means that the failure of the breakout must occur within the same candle or bar.

The pattern can be applied to a bullish or bearish scenario:

The bullish fakeout:

This occurs when the market breaks below a key level of support only for the breakout to fail and for the market to close back above the support level.

In trading, a picture really is worth a thousand words so check out the chart below. And if you want to take your learning of this pattern to the next level then please try and hunt down as many examples of this pattern as possible.

NOTE: The horizontal support level and the fakeout candle must be on the same timeframe - the chart below is the daily candle chart but you can trade this pattern on any timeframe.



The bearish fake-out:

This occurs when the market breaks above a key level of resistance only for the breakout to fail and for the market to close back below the resistance level.

Here’s an example on the hourly candle chart:



Here’s an example of bullish and bearish setups forming when a market starts to trade in a sideways range:



Why the fakeout can be so powerful

The fake-out pattern can be so powerful because it can exploit herd behaviour in a deliciously effective way.

When a market starts to breakout, FOMO (Fear of Missing Out) may herd traders into the market. This fear could drive them to enter positions hastily, often without waiting for confirmation.

Then, as the breakout starts to fail, the herd may head for the exit and panic sets in as trapped traders cover losses.

II. How to trade the fakeout:

Identifying and anticipating the fakeout: First and foremost, traders need to identify key support and resistance levels. It’s worth setting a price alert at these key levels so you’re alerted to when the market tests them. When the level is tested, set a time alert for when the candle closes. Through the disciplined use of price and time alerts, you’re unlikely to miss a fakeout again!

Entry Points: For bullish fake-out patterns, a trader may enter on a break above the fake-out candle high. For bearish fake-out patterns they would enter on a break of the fake-out candle low (see chart below for example).

Stop-Loss Placement: Traditional stop placement for the pattern is above or below the tail of the fakeout candle depending on if you’re going long or short. An alternative stop placement method is using a volatility-adjusted stop such as placing your stop a multiple of the Average True Range (ATR) away from the current price. Whichever method you use, be consistent.

Price Targets: A limit order to take profit at the next level of support or resistance can be a robust approach to profit taking for this pattern. Alternative methods include taking a set multiple of risk or trailing stops to lock in profits.

Bullish scenario:


Bearish scenario:


III. Three simple rules that could increase the patterns effectiveness:

Rule 1: The more prominent the level, the more powerful the fakeout can be
Support and resistance levels should be clear and obvious, a breakout above or below multi-day or multi-week highs or lows are likely to gain the most attention, meaning a higher number of trapped traders should the breakout fail.

Rule 2: The longer the tail, the more powerful the fakeout could be
The tail of the breakout candle represents the prices which the market was pushed to prior to the breakout failing. Longer tails typically indicate a higher number of trapped traders.

Rule 3: The less consolidation near the level, the more powerful the fakeout
Traders should be wary when price starts to consolidate just below a key area of resistance or just above a key area of support. This ‘base’ raises the probability of a breakout holding.

IV. Managing Risks and pitfalls:

Risk Management: Implement proper risk management techniques, such as position sizing, setting stop-loss orders, and diversifying your trading portfolio. This helps protect against unexpected market movements and potential losses.

Additional Analysis: Don't rely solely on the fakeout pattern for trading decisions. Supplement your analysis with fundamental factors and market sentiment to gain a comprehensive view of the market.

Disclaimer: This is for information and learning purposes only. The information provided does not constitute investment advice nor take into account the individual financial circumstances or objectives of any investor. Any information that may be provided relating to past performance is not a reliable indicator of future results or performance.