Trading 101

Article #2 Fakeouts. What are they? How to spot and avoid them?

Many traders and especially their capitals suffer from huge losses due to ‘fakeouts’. But what is a ‘fakeout’ in trading and how can we avoid it or at least preserve our capital? We will try to answer those questions in this article and hopefully will shed some light on this devastating formation.
First of all lets’ start with the question “What is a ‘fakeout’?”. Simply put a ‘fakeout’ is a term used to describe a situation in which a trader has opened a position in anticipation of a future price movement in a certain direction, but this movement never develops and the price moves against the trader in the opposite direction. To break that down for you lets’ use a simple example:
Imagine you are looking at a certain market and you are using the 200 SMA as a support or resistance level. You see on the H4 chart that the price breaks through the 200 SMA line with a nice bullish candle which is a good indication for a future uptrend. You open a trade anticipating the price to continue up on the next few candles reaching a certain area, but the price movement suddenly reverses on the next H4 candle and goes below the 200 SMA, thus hitting your Stop Loss and thus adding a losing trade to the stockpile of trades you have. This example shows what a ‘fakeout’ means.

If you are interested in how to use the 200 SMA as support or resistance level you can check this article:

https://medium.com/@dmtradingbg/trading101-f3746621fc26

Now that we know what a ‘fakeout’ is, so lets’ get to the topic on how to spot them and most importantly how to protect from them.
Spotting a ‘fakeout’ is usually easy when it has already occurred, but spotting it before that can be a great challenge even for experienced traders. In the next paragraphs I will try to explain you how to spot a ‘fakeout’ or actually the possibility of a ‘fakeout’ early so you don’t get trapped in and I will also explain how to preserve your capital if you get trapped in a situation like that, because it happens even to the best.
Most of the traders including myself use different signals when going for an entry on the market. These signals can vary — you can use the SMA, you can use price action, you can use the MACD or RSI indicators etc. The most important thing in order to avoid ‘fakeouts’ is to always use more than one signal for entry. Using only one indication or signal for entry would result in many losses due to ‘fakeouts’ in the long run. This is the best way to protect yourself and your capital from those terrible situations. Lets’ continue with our example above in order to show you what I mean:
This is the H4 time frame of the EUR/USD currency pair. You can see that we have the 200 SMA and an uptrend which is being shifted into a downtrend. As you can see we don’t rely just on the break of the 200 SMA to jump in and open a Short (Sell) position, but we have 2 more confirmations that this could actually be a profitable spot. The first of which is that the pair is currently in a downtrend confirmed by the Lower Highs. The second thing is that the break is not only on the 200 SMA but with the same candle the pair is breaking the two previous bottoms. This is what can be called a multiple signals set up.

Now if you are still not sure about the entry here and since in this case we are looking for an entry on the H4 time frame, it is good to check what the situation is on the Daily or even Weekly time frames in order to increase our chances of a profitable trade.

We can see on the Daily timeframe that after a huge and long uptrend the price started to consolidate forming a zig-zag formation. We can also notice that the 200 SMA which can act as support or resistance is far away from the current price levels. When the H4 break occurs we can see on the daily that the price has already made a few Lower Highs and is currently breaking the consolidation area support. This is more than enough for you to open a position without being nervous that you might witness a ‘fakeout’ although it is never 100%.

Lets’ also look at an example in which you have just used the 200 SMA as a signal to invest.

Again the pair is EUR/USD and we are looking at the H4 time frame. You can see that the price has broken through the 200 SMA and this is a signal for entry. Now in this example, we are jumping straight in on the market just because of the break, without having additional confirmations. As you can see in this case we would have been caught up in a ‘fakeout’ and this would have been a losing trade. By entering just on one signal we have neglected the fact that this candle, although breaking the 200 SMA, did not break the previous bottom which the price formed. Another thing we did not notice is that the current wave down is pretty old and there was no decent correction to that move. If this is not enough lets’ look at the Daily time frame.

Firstly, we can see that the currency pair is in an uptrend. Second of all, we had a small consolidation, a strong move up followed by a small correction and another move up. The current wave down is still in the zone formed by the previous correction, but it is not breaking it. As you can see the break of the 200 SMA is exactly at the line of the last bottom formed by the previous correction on the Daily time frame, which means that we are entering on the worst spot.
So as you can see from the examples above, the best way to avoid being stuck in a ‘fakeout’ is to follow a few simple rules:

• Always have more than one confirmation signal for entry — a combination of two or more gives you a better edge on the market
• Always consider your entry spot on multiple time frames, meaning that if you are going to open a position on the H4 time frame make sure to consider where you stand on the higher time frames like Daily or even Weekly
• If you are getting a mixed signal it is better to avoid the current trade and wait for a new opportunity.

But what if you finally find yourself in a ‘fakeout’ situation. Well during my time as a trader I have found out that the best approach if you got stuck in a ‘fakeout’ situation, is to try and minimize your losses. How to do that?
Imagine you are in a situation where the market gives you an entry spot. You jump in with an investment, but the price movement reverses. There are a few ways to minimize your losses in those cases and I will outline them below:

• If you open a position on a certain candle on a certain timeframe and the next candle is a reverse (opposite) this can be very likely to be a ‘fakeout’ and I would suggest you close 70 or 80% of your position in order to protect your capital

Example and Explanation:
You find a good spot for entry on a nice bullish candle. You pull the trigger and you are in on a Long(Buy) position. All of this happens on the H4 time frame. The next H4 candle is bearish which should immediately indicate you that this might be a ‘fakeout’. Close 70–80% of your position at the end of the H4 candle. This is an issue because you assuming that the price should continue up or down after a certain confirmation signal and actually it goes in the reverse direction, the chances of a ‘fakeout’ become a lot more significant.

• After going for an entry on the H4 timeframe and already 1–2 hours have passed and you did not see much of a move, you go to the M30 timeframe and you spot a consolidation being formed there. This is again a good spot for you to close some percentage (70–80%) of your position due to the fact that this might actually be a ‘fakeout’.
• Hedge your trade. After you go for an entry due to certain move up or down, which is a confirmation signal, and the price quickly reverses the direction in which it is moving, it is a good spot to open a reverse position — if you are in a Buy position, open a new Sell position and vice versa. This gives you the ability to win with one of your positions if you lose with the other, thus protecting your capital and minimizing the losses.

I do hope this article would give you an advantage in your trading and would help you protect yourself from ‘fakeouts’, minimize your losses if you find yourself in a situation of a ‘fakeout’ and thus increase your profits in the long run. I’ll see you in our next Trading101 educational article and until then — practice what you have learned today as practice is the key to success.

Written by Ilian Iliev

15.03.2018