Price action refers to the changes of a security's price over time. Since it can be seen and interpreted using charts, it forms the basis of the technical analysis. Traders use different chart compositions to enhance their ability to spot and interpret trends, breakouts and reversals.
Even though interpreting price action is subjective, it can be very useful and help maximise your trading results and hence profits. How? Technical analysts believe that past trading activity and price changes can be valuable indicators of future price movements, which means that certain patterns and signals can forecast the upcoming price movement with a high probability, which is based on historical evidence.
There are hundreds of patterns and indicators used by traders that rely (solely or partly) on technical analysis, to maximise their chances of walking out of the trade as a winner. Unfortunately (and quite obviously) none of them works with a 100% certainty.
Sometimes the setup can be perfect, but fundamental factors may cause a signal to not develop as planned, but even if there are no other factors that could affect how things turn out, most indicators work with around 70% probability, which means that there is no guarantee and in approximately 3 instances out of 10, things won’t turn out in accordance with your expectations.
An example of a move against expectations is a fakeout, which is going to be a focal point of this article. It will teach you not only how to spot fakeouts, but also how to turn them to your advantage. Are you ready? Let’s get right into it!
What is a fakeout?
A fakeout, or ‘false breakout’, occurs when the price moves outside of a chart pattern but then moves right back inside it. After the breakout occurs, a further movement in the direction of the break is expected. When a fakeout takes place, these expectations don’t materialise and the price not only fails to move in the direction of initial move, but even produces a significant move in the other direction.
An instance of a fakeout can be obtained from the picture below, which shows the price in a bearish trend that breaks through a support line. Having broken through, the price quickly makes an impulsive move upwards (the opposite direction of the initial move) and begins its climb higher, as the trend reverses from bearish to bullish.
How to detect fakeouts?
Potential fakeouts are commonly found at support and resistance levels created through horizontal or tilted trend lines, moving average lines, chart patterns, a Fibonacci level, etc.
A break of a support line is a bearish signal that indicates that a price will likely keep moving downwards. On the flip side, a break through a resistance line is a bullish signal that indicates the price is likely going to move further upwards, as buyers overcome the sellers.
Unfortunately (or fortunately if you know how to deal with them) breakouts often tend to , if the move isn’t supported by other indicators.
One of indicators you should keep your eye on the volume indicator:
Breaks on low or decreasing volume are likely to be fakeouts
Breaks on high or increasing volume are likely to be real breakouts
Another distinguishing between valid breakouts and fakeouts is with the help of RSI, a momentum indicator that measures the strength behind a move by measuring its speed. If the RSI is increasing and making higher highs and higher lows, it means that the momentum is building, while to lower lows and lower highs signals that a trend is losing momentum.
If the price makes a breakthrough and the RSI is building momentum you’re likely dealing with a valid breakout.
If the price makes a breakthrough and the RSI is showing downward momentum you’re likely dealing with a fakeout.
How to trade fakeouts?
Fakeouts don’t need to be a frustrating part of your trading journey. In fact, false breakouts can provide profitable setups if you know how to trade them. As already mentioned, the most helpful indicators in recognizing fakeouts are volume and RSI. Therefore you’re going to use either one of them (if you’re more prone to risk) or both of them to get a confirmation to enter a position.
Let’s say that you spot a breakthrough of an important support/resistance level in conjunction with low or decreasing volume. On top of that, the RSI indicator is also showing decreased momentum. That is a signal that you should enter a trade. Once your order gets filled, you should trade as long as indicators continue to support your trade direction. Usually when dealing with fakeouts, the low trading volume during the breakthrough is going to get replaced with a pick up in the volume during the time of the pullback and beyond. If you spot a drop in the volume, then the price move might be getting exhausted, and it might be wise to close the trade.
Nevertheless, it is always a good idea to pre-define your profit target. It’s recommended to look for the next strong areas of support/resistance and exit around these levels. Additionally you can look for formations of chart patterns, which can help you determine where to collect your profit. You can even do so gradually, by exiting partly at various levels.
How to protect yourself against significant losses?
Fakeouts can lead to significant losses, therefore professional traders always use stop losses to control risk. Deciding whether or not you should use stop loss too is a no brainer. Of course you should. This is the only way you can protect yourself from incurring significant losses. A more appropriate question you should ask yourself is ‘Where should I set my stop loss?’. Generally, you should place a stop loss a little lower than the low of the most recent candlestick when going long. Contrarily, you should place a stop loss a little higher than the high of the most recent candlestick when going short. Another method is to place a stop loss just below (or above) the moving average support (or a resistance).
How much higher or lower? Frankly, it depends on your trading style and the amount of risk you’re willing to take. In any case, the distance between your entry point and your stop loss needs to be much smaller than the distance between your entry point and your profit target. Many professional traders only take trades that have potential profit at least three times greater than the risk, so you should probably aim for something in that range. A little higher, if you’re more prone to risk and a little lower if you’re a more conservative trader.