One of the most important calls you will have to make as a forex trader is whether a breach of a particular support or resistance level is ‘real’ or not. With most technical strategies, identifying support and resistance is vital to good technique and consistent profits. ‘Fakeouts’ – or false breakthroughs of support levels – are one of the most challenging problems to identify and avoid.
Support and resistance
As you probably already know, support and resistance levels are key concepts in technical analysis. They both refer to a price point that has been repeatedly approached by the live market price, but either not exceeded (resistance) or fallen beneath (support). The more times a support level has ‘held’ the price – when it is approached but not crossed – the stronger chartists consider it to be.
Support levels in particular have a vital role in your risk management strategies, as they provide a convenient and effective place to put your stop losses. By positioning a stop loss on a long trade just below a key support level, you are protected in the case of adverse market conditions, without having your stop unnecessarily triggered by normal fluctuations in price.
Indeed, traders should put just as much care into choosing their stop loss as their target price or take profit level. Keeping the stop loss closer to the support level may increase the frequency of unnecessary stops, but it will also limit your losses in the case of a genuine downward breakout.
Technical strategies identify particular market trends – strong continued movements in a particular direction. The consistent drive of the market in a particular direction is known as momentum. Momentum explains many technical analysis concepts as the herding behaviour seen during market rallies, or during sudden reversals, accelerates the more traders join in.
Typically, momentum is limited by support and resistance levels. Because many traders set their take profits or stop losses at these key levels, there can be failed attempts to cross the resistance, where the actions of traders taking profits (or short trade stop losses being triggered) pushes down the price just as it looks on track to start a breakout.
Successful breakouts happen when a previous resistance level is breached, and the market gathers momentum as traders expect the asset to soar onwards to new heights. A downward breakdown is an identical process in a lower direction. This marks the beginning of a new trend.
When the impact of stop losses causes a loss of momentum and retreat from the key level, the resulting reversal is not a true ‘fakeout’ as the resistance level is never crossed, but these false breakouts still demonstrate the same market principles.
True fakeouts occur when the price breaches a support or resistance level, before quickly returning below to trade in its old range. ‘Fakeout’ is also used as a colloquial term to refer to the both the false breakouts described above and actual fakeouts.
Both of these events can be a real problem. For example, if you are using a technical strategy where you enter trades the moment they cross a resistance level, each time the price crosses the resistance barrier, you will want to be sure that the upwards price action will continue, or you may be stopped out.
If you go long on a trade because the resistance level is briefly exceeded, but the price then moves back down below to continue trading in the old range, it is possible that the trade will be stopped out with a loss, or at the very least continue open for far longer than you’d hoped – something to be avoided in day trading.
Why do fakeouts happen?
There can be several reasons for a false breakout. The important thing to remember is that support levels are not precise – particularly when they are drawn by angled lines from a range of prices, the exact charting of the line could differ slightly from trader to trader.
Experienced traders will know to view their resistance line as a band of probability, rather than a neatly defined line. One easy trick for not becoming overly reliant on falsely precise readings is to use a thicker line on your charting software.
Also, some resistance levels only hold between sessions. If you are looking at a one-day time period candlestick chart, it may be wise to wait until a day closes above a resistance level before you consider the breakout confirmed. Doing so will mean you miss out on some of the price gains from the bottom of the trade, but it reduces the likelihood of you unintentionally trading a fakeout.
Finally, be wary of support levels obtained from tools like the Fibonacci retracement; though they can be effective, they are notoriously subjective and can suffer from ‘fitting’ – where a trader changes the initial position of the retracement to fit the chart more closely.
How can fakeouts mislead traders?
There are a range of ways that fakeouts can catch out traders:
- Traders might enter trades based on a false rationale – for example, entering a short trade thinking a support level has been breached, when it is still intact.
- Traders might set inappropriate stop losses – an aggressive long trade might use an old resistance level as a stop loss, betting on a price surge past the breached level. Should the resistance level turn out to be anything but old, this guarantees a loss.
- More subtly, repeated fakeouts might cause a trader to double guess the market or doubt his own analysis. This can damage his overall mindset and cause other careless mistakes.
Fortunately, there are some methods for avoiding these dangers, chief among them the use of alternative chart types to try and reduce the frequency of false breakout signals. Whatever method you use, always approach any price movement with scepticism, and wait for confirmation of a trend before plunging into trades.
Point and figure charts
Several additional chart types exist to help minimise the danger of trading fakeouts. A classic example, though one that is sadly nearly unknown today, is the point and figure chart. The point and figure chart plots a new column each time a particular price change is recorded.
When the price increases, a column of Xs is written up to the level of the price (plotted on the y axis), and when the price decreases by the same amount, say $0.01, a column of Os is written.
Each O or X represents a fixed unit of price. This means the x axis records successive price movements and not time. A period of completely flat sideways trading would be shown with a single column.
A point and figure chart can often help reveal patterns more clearly, and because of the minimum movement size it ‘cleans up’ the signal of price history. Since patterns form at different speeds, they may become distorted on real-time charts, an effect which is neatly countered by the point and figure setup.
Nevertheless, fakeouts remain possible with point and figure charts, though they are considerably less frequent. If you are not sure, you may either wait, or enter the trade with a tight stop loss.
Something to remember
Every trading strategy will include a certain number of missed or failed trades. These are not mistakes, but an important part of reaching your goals in a strategy based on a certain percentage of the long-term average being wins. Fakeouts may inevitably be one of the ways you miss out on trades.
An attitude of caution and waiting for confirmation can help, as can the use of alternative charts like the point and figure, but it is important not to expect to eliminate them totally. Failed trades are a key part of any successful strategy, no matter how frustrating they may seem at the time.
How Rakuten can help
Fakeouts are a frustrating fact of life for technical traders, but there are some steps you can take to help identify them. If you feel ready to take your forex knowledge to test, why not open a free demo account today and start placing trades without risking any of your capital?