“Fading false breakouts” strategy
This lesson will cover the following
- A quick overview
- Steps a trader needs to follow for this strategy
At some point a trader may encounter a potential breakout scenario, position himself/herself accordingly only to see a failed trade, because the market has returned once again to a trading range. In case the price indeed manages to breach above a key level, it is not 100% certain that this move will actually continue. As breakout levels are of utmost significance, there is no rule as to what force is needed in order to push the price beyond these levels (and form a resilient trend).
Trading breakouts from key levels is accompanied by high levels of risk, while because of that it is a more common case for a trader to witness a failed breakout rather than an actual one. Also, as the market will usually attempt to test a key resistance (or support) level more than once before a breakout occurs, many traders have devised countertrend approaches (looking for an opportunity to fade breakouts). However, fading any breakout may lead to huge losses, because as soon as the actual breakout occurs, a resilient and lasting trend begins.
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Fading requires a trader to examine consolidation setups in order to detect a suitable entry (into a trade), which has a higher potential to become a failed breakout. In this case a trader will usually rely on daily charts to detect trading ranges and on 1-hour or 4-hour charts to position himself/herself.
What does a trader need to do?
There are certain steps, that are to be followed, in order to implement the “fading strategy”.
When going long:
the trader will need to wait for a price move of at least 15 pips below the low of the prior trading day;
the trader will place an order to buy 15 pips above the high of the prior trading day;
the trader will take profit as soon as the market moves to the upside by at least 60 pips (or two times his/her risk exposure).
When going short:
a trader will look for a currency pair, having a 14-period Average Directional Index (ADX) less than 35, or an ADX currently in a downtrend (which implies further weakness);
the trader will need to wait for a price move of at least 15 pips above the high of the prior trading day;
he/she will place an order to sell 15 pips below the low of the prior trading day;
the trader will take profit as soon as the market moves to the downside by at least 60 pips.
This trading approach needs to be implemented at times when no crucial macroeconomic reports are to be released (because the latter often lead to huge moves in one or another direction). Consolidation can usually be observed during the hour just preceding the release of key economic data such as Unemployment rate and Change in Non-farm Payrolls in the United States. Consolidation is a result of indecision among market players (some of them may have already positioned themselves, while others may prefer to act right after the data is published. What needs to be noted here is that any breakout, following such key releases, has a potential of becoming an actual one, so fading it is not recommended. All in all, this approach is best used with currency pairs of lesser volatility!
Let us examine the 1-hour chart of USD/CAD. The 14-period ADX has dropped below 35, so, at this point we can begin looking for a breach below prior days low (1.0864) by 15 pips. After this break occurs we can begin looking for a break above prior days high (1.0876) by 15 pips. After we see this occurring, we make a long entry at 1.0891. Our protective stop is placed 30 pips below the entry price, at 1.0861, while the profit target needs to be 60 pips above the entry, at 1.0951. Later our order gets filled for a profit of 60 pips, while we risked 30 pips.