Trade false Forex 'fakeouts' in 5 steps
Is there anything more frustrating than taking a forex false breakout trade to have it fade back into its previous range and stop you out?
What if you could learn to take advantage of these so called ‘fakeouts’ with a clear, simple trading system that has a great risk to reward ratio? Perhaps a false breakout trading strategy?
Here is a strategy I have been using to successfully take advantage of false breakouts that occur on a regular basis on different currency pairs.
I’ll take you through a trade I took recently so you understand this strategy in 5 simple steps.
Step one: Identify support and resistance
I am a strong believer that support and resistance levels should be obvious. I am interested in levels everyone else is aware of and looking at. An exercise I often suggest is to take a blank chart on the time frame you are interested in and then mark-up the support and resistance levels as quickly as possible.
Here is a blank GBP/USD pair chart on the weekly timeframe:
Here is the same chart with major and obvious support and resistance marked up. You can learn more about support and resistance here.
This is the foundation from which I will work from.
For our trade, the low of 2019 at 1.2411 is of interest to us as it is a major and obvious support level.
Traders over-complicate support and resistance. Most people reading this blog are ‘retail traders’ – they use CFDs or Spread Bets to trade – so they’re sitting ‘on top’ of the real market. This detail doesn’t matter, what I am telling you is that your trade doesn’t matter to the market. It won’t move the market or have an influence on it. This isn’t an issue – we don’t need our trades to – but it leads me to my point. We need to be riding on the back of traders who are moving the market.
This is why we are looking at the big levels everyone else is looking at is essential. If there’s a major, obvious support and resistance level, we want to be planning trades around it. Whether using this strategy or something like our breakout trading strategy.
Step two: Wait for the break of the level
We need to see a lower-low through the 1.2411 to set our trade up. Once this happens we become closer to taking a trade.
Whilst the price is below our support level we do not do anything other than wait and be patient. No jumping the gun or trading before our setup has occurred!
If the market wishes to continue down and become an actual breakout then so-be-it. We have no entry and we do not chase the market. We await the next trading opportunity and we remind ourselves that with trading, there are always more opportunities around the corner.
We also want the market to move a reasonable distance through the level. Not just a few pips. This will depend on the specific pair you are looking to trade and the current levels of volatility. For GBP/USD, at least 25 pips are needed to set the trade up, but with experience you will develop a feel for the when the ‘fakeout’ is enough.
If we are going to get an opportunity, we will see an exhaustion of the sellers. Often with one last push down into a new low to create a ‘bear trap’ (where new sellers get trapped in short positons and quickly squeezed). The 7am hourly candle marked above is a perfect example of this. One last push to take the market to a new low.
How many times have you fallen into a trap like that where you seem to go short just as the market reverses?
A big trader error is taking the wrong entry or deviating from a planned entry. Remember, it’s easier to see a trading setup and much harder to execute it correctly. Compromising your entry or trying to preempt the setup BEFORE it has happened will lead to stress and failure.
It’s not quite as bad with this strategy as others, because you need to the market to come back to where it has previously been, but there are still risks. Avoid:
– Entering the trade before it has ‘faked-out’.
– Entering the trade before it has come back above the support or resistance level you are working from.
After reading this article I’d recommend watching this video to reinforce the lessons. This is definitely a strategy you need to understand and implement. We have lots of really useful content on YouTube so make sure you subscribe for updates. Here is the video of the false breakout trading strategy:
Step Three: Placing the entry
We are looking for a break back into the previous range. A break back above the support level.
It pays to remember that there’s a balance between opportunity and confirmation when it comes to an entry. On one hand, the more aggressive you are to enter the market – the closer your entry is above the support line – the earlier you are in a trade if the ‘fakeout’ does go on to play out. On the other hand, the more the market returns into the previous range, the more confirmed the move is at the expense of a better entry.
On this trade I placed my entry just above the previous overnight ‘noise’ at 1.2424. The GBP/USD pair usually trades slow and sideways when the European and US markets equity markets are closed and I wanted the market to be clear of this before entering in the trade.
This entry is suitable to be taken on order (as opposed to manually ‘at market’), so is suitable for people who may not be able to monitor the markets continuously.
Step four: Placing the stop
One of the big strengths of this strategy is you have a clear and unambiguous level to place your stop loss. This is below the low of the ‘fakeout’. Here it was placed at 1.2375, a few pips below the lowest point of the ‘fakeout’.
When you know where to place your stop you can then manage your risk and get correct position sizing.
Do not place a trade unless you have figured out where your stop is.
Step five: Taking profit
The way I like to set profit targets with this strategy is to look for a swing to pull a Fibonacci retracement. Once that is done I look to scale-out (partially close my position) 50% just below the 50% Fibonacci retracement.
The second profit target depends on your trading style and judgement fundamental factors. If you are fighting a fundamentally weak currency (as the pound has been during the Brexit uncertainty), then you may choose to close the remaining 50% somewhere prior to the full retracement.
Alternatively, you may wish to leave the second 50% to see if you can catch a big swing trade. This can be a great strategy, and learning to identify swing trade opportunities can leave to some of the your biggest trades (and largest profits) of the year.
If you are looking to capture a big move in the market and turn this in to a swing trade, then you need to look at trailing your stop loss and locking-in profit. This is done by looking at the price action of the market and deciding where you don’t want to see the trade go in order for it to be invalid.
For example, on this major down-trend on the GBP/USD currency pair, the market pulls-back multiple times (goes against the main trend). This gives stop loss placement as if these lower-highs (the pull-backs) are breached, then we want to be out of the trade as it is no longer valid as the trend is broken.
There are certain ways to start adopting a new strategy. Here is the way I recommend:
- Start off by trading the strategy on a demo account. This will help you with the technical implementation of the strategy (i.e. correct, entry, stop and limit use). Once you have a decent sample (number of trades taken), you can assess whether the trading strategy is for you or not.
- If you decide the trading strategy is for you, then you can move on to the next stage. Trading the strategy at a smaller size. I recommend 1/4 your usual risk levels. If you’ve traded both demo and real accounts you’ll know there are vast psychological differences between the two. Trading with a smaller size allows you to start to build your confidence in the strategy. Confidence is essential when executing a trading strategy as you have to face things like draw down.
- Increase your trade size if you are making a profit when trading at a smaller size. This once more underpins confidence in the trading strategy. At this stage your sample of trades will also be larger allowing you to fine tune the strategy, which is the stage you need to be at when undertaking full risk levels.
- Watch professional traders plan, execute and manage these trades to learn. We run a live trade room where we do exactly this. Find out more information about that here.
These trades need to be taken on a H4 (four hourly) or daily time frame. They aren’t ‘day trades’. They are suitable for people who want swing trades that are likely to last days, and more importantly, are suitable for people who work full-time / a 9-5 job. The reason being is that a trader can do their analysis in the evening or at the weekends.
In fact, sometimes working and trading alongside is the best way for a trader to develop. Not just because of the financial security, but because they have something else. They have something to stop them interfering with their own trades. The worst thing a trader can do is sit and watch a longer-term trade, tick by tick, minute by minute. The temptation can become too great to adjust the trade.
Of course they’re also suitable for the professional, full-time trader. The professional, full-time trader who is happy to let trades run without interfering with their trading plan. A lot of professional traders will have a false breakout trading strategy.
Which forex markets are best to trade?
This is a strategy aimed primary at Forex. It works on every pair but different pairs have different ‘personalities’ to others. This is true of every market and a part of becoming an experienced trader is to learn the ‘personality’ of the markets which you trade. We like to trade the major pairs like the GBP/USD, EUR/USD and GBP/EUR. The reason being is that we are based on the UK and these are the major western Forex pairs and we are awake when they are being traded. You may live the other side of the world, so test this strategy on the pairs that most suit you.
This is a strategy that can be used and adapted for other markets. It’s a valid entry on indices, for example. You’ll often see ‘fakeouts’ on the FTSE, DAX and DJIA. It’s also possible to trade it on lower time frames like the 5-minute time frame as part of looking for more frequent reversal trades.
The false breakout trading strategy is a reversal strategy. You often hear ‘don’t go against the trend’, but this is an over-simplification of trading. There is nothing wrong with going against a trend if the trade is a part of a legitimate strategy that has an edge / positive expectancy.
Trading strategies require a consistent approach, and this one is no different. The steps have to be followed correctly and assessed individually to ensure the rules of this strategy are being correctly followed.
- Identify major support and resistance levels
- Wait for the market to break those levels and enter a new trading zone
- Place your entry back in the previous zone
- Place your stop below / above the ‘fakeout’
- Take profit at the 50% Fibonacci retracement and then decide on how to manage the second 50%