Trading is no different from a real-life business. However, in trading, psychology is a critical factor to consider. Trading is not all about analyzing patterns, indicators, etc. But, it is about understanding the essence of the market’s price action.
In the real-life business, there is no concept of 95:5, but in trading, such a concept does exist. The sole reason for it is, again, psychology.
Now, you might be wondering why we are discussing psychology. Note that psychology and fake-outs go hand in hand. A false breakout (fake-out) is not merely a pattern; instead, it’s co-related to human trading behaviour.
In this educational article, we shall be discussing the concept of fake-outs by applying price action techniques.
What are fake-outs?
By definition, a fake-out is a scenario in the market when the price temporarily breaks above or below a key level (Ex: support and resistance), but then retreats back to the same price where the break out happened.
However, knowing the definition won’t take a trader anywhere forward into trading. What matters is the logic behind the occurrence of a fake-out.
How to identify and confirm a fake-out in the market?
There are no rules as such to identify a fake-out.
A professional trader identifies a false breakout even before the price gets rejected from a key level. On the hand, amateur traders identify (confirm) a fake-out after the price gets denied from a key level.
Here, we shall be discussing on verifying the authenticity of a fake-out rather than the technique to identify it, as identification is not a lesson which can be taught.
To confirm a fake-out, understanding the concept of timeframes is quite necessary. To analyze the markets, we consider two timeframes; one to determine the flow, and another to dissect the market. The flow is determined on a higher timeframe, and the rest of the analysis is done on a lower timeframe. The fake-out is spotted on the lower timeframe and is verified on the higher timeframe.
Considering the below chart to be the lower timeframe, we can see that the market was holding above the purple support level. Later, the price broke below the support and came back up to the purple line. Now, was the break out is real or fake? To determine this, we go up a timeframe.
From the below chart (higher timeframe), we can see that the market went below the purple line and came right back up in just two candles, and held above the purple support line. Hence, we can call it a fake-out.
The reason behind the occurrence of a fake-out
Now that we know to identify/confirm a genuine fake-out, we must also understand why fake outs happen in the market. Here, we pick up the Introduction from where we left.
Psychology has a vital role in the occurrence of a false break out. Trading is basically buying and selling of products (here, currency pair). To buy something, you need someone to sell it to you. And, to sell something, you need someone to buy it from you. Talking about Forex, for the big players to buy a currency pair, they need a massive amount of people to sell it to them. And, for them to sell a currency pair, they need loads of people willing to buy it from them. In simple terms, the big players want/need the public to take the opposite trade of what they take. Well, let us understand how big players make this possible.
When the market is shooting up north, what do you think is the public doing? They are obviously buying, and so are the big players. If both are buying wanting to buy, who are they going to buy it from? In other words, since everyone is buying, there is nobody to sell it to them. Hence, now they cannot buy until one of the parties switches their perception and begins to sell.
Since the big players are the market movers, they start selling the currency pair to the public; as a result, the price drops. Seeing the prices drop, the public begins to jump on the sell. And this sell order is utilized by the big players to hit the buy, which makes the market shoot up suddenly.
In a nutshell, the whole above scenario is referred to as a fake-out.
Taking advantage of fake-outs: A complete trade example
Considering the below chart to be the higher timeframe, we can see that the market broke below the purple S&R level and held below it. Since the market is in a downtrend, we must focus on going short.
Below is the chart on the lower timeframe. We can see that when the market broke below the S&R level, the price held below it and started to range. And, at this point in time, everyone is looking at it as a sell. But, later, the market shot up north by breaking above the purple line. Now, the public who were selling begin to hit the buy. However, for us, it doesn’t change the fact that the market is still in a downtrend.
Moving forward; from the below chart, we can clearly see that the market shot right back down and began to hold inside the purple line. From this, we can surmise that the price went up only for the public to turn into buyers. Once they turned into buyers, the big sellers triggered their sell order, which made the market fall down back into the purple line. Hence, this gives us an indication that the sellers are all set to go further down.
A stop-loss above the S&R (purple line) or above the fake-out would be good and safe enough.
The recent low would be the typical point to book your profit. After gaining some experience, one can aim for new lower lows as well.
A Fake out is that concept in trading, which basically plays with the emotions of the public. However, looking at the good side of it, fake-outs are extremely powerful in determining the entry point of a trade. And, an example of the same is given above as well.
Always be patient before taking a trade, because the price might end up being a false breakout. So, always take advantage of a fake-out by entering the trade after the fake-out happens.