In order to fade breakouts, you need to know where potential fake outs can occur.
Potential fake outs are usually found at support and resistance levels created through trend lines, chart patterns, or previous daily highs or lows.
In fading breakouts, always remember that there should be SPACE between the trend line and price.
If there is a gap between the trend line and price, it means price is heading more in the direction of the trend and away from the trend line. Like in the example below, having space between the trend line and price allows price to retrace back towards the trend line, perhaps even breaking it, and provide fading opportunities.
The SPEED of price movement is also very important.
If price is inching like a caterpillar towards the trend line, a false breakout may be likely. However, a fast price movement towards the trend line could prove to be a successful breakout. With a high price movement speed, momentum can carry price past the trend line and beyond. In this situation, it is better to step back from fading the breakout.
How do we fade trend line breaks?
It’s very simple actually. Just enter when price pops back inside.
This will allow you to take the safe route and avoid jumping the gun. You don’t want sell above or below a trend line only to find out later that the breakout was real!
Using the first chart example, let’s point out possible entry points by zooming in a little.
Chart patterns are physical groupings of price you can actually see with your own eyes. They are an important part of technical analysis and also help you in your decision-making process.
Two common patterns where false breakouts tend to occur are:
- Head and Shoulders
- Double Top/Bottom
The head and shoulders chart pattern is actually one of the hardest patterns for new traders to spot. However, with time and experience, this pattern can become an instrumental part of your trading arsenal.
The head and shoulders pattern is considered a reversal. If formed at the end of an uptrend, it could signal a bearish reversal. Conversely, if it is formed the end of a downtrend, it could signal a bullish reversal. Head and shoulders are known for generating false breakouts and creating perfect opportunities for fading breakouts.
False breakouts are common with this pattern because many traders who have noticed this formation usually put their stop loss very near the neckline.
When the pattern experiences a false breakout, prices will usually rebound. Traders who have sold the downside breakout or who have bought the upside breakout will have their stops triggered when prices move against their positions. This usually is caused by the institutional traders who want to scrape money from the hands of individual traders.
In a head and shoulders pattern, you can assume that the first break tends to be false.
You can fade the breakout with a limit order back in the neckline and just put your stop above the high of the fake out candle.
You could place your target a little below the high of the second shoulder or a little above the low of the second shoulder of the inverse pattern.
The next pattern is the double top or the double bottom.
Traders just love these patterns! Why you ask? Well it is because they’re the easiest to spot!
When price breaks below the neckline, it signals a possible trend reversal. Because of this, plenty of traders place their entry orders very near the neckline in case of a reversal.
The problem with these chart patterns is that countless traders know them and place orders at similar positions. This leaves the institutional traders open to scrape money from the commoner’s hands.
Similar to the head and shoulders pattern, you can place your order once price goes back in to catch the bounce. You can set your stops just beyond the fake out candle.
What kind of market should I fade breakouts?
The best results tend to occur in a range-bound market. However, you cannot ignore market sentiment, major news events, common sense, and other types of market analysis.
Financial markets spend a lot time bouncing back and forth between a range of prices and do not deviate much from these highs and lows.
Ranges are bound by a support level and a resistance level, and buyers and sellers continually push prices up and down within those levels. Fading the breakouts in these range-bound environments can prove to be very profitable. However at some point, one side is eventually going to take over and a new trending stage will form.