Fading breakouts refers to trading against breakouts. When we believe that breakouts from support and resistance levels to be false and unsustainable we fade breakouts. Suppose you believe that the currency prices will not be able to follow through action in the direction of the breakout. You trade in the opposite direction of the breakout. False breakouts are a bane for breakout traders but boon for breakout faders. False breakouts are also known as fakeouts. Fading breakouts tends to be more effective as a short term strategy. Fading breakout is not meant to be a long term strategy.
Support and resistance are seen as the price floor and the price ceiling respectively. Support level attracts the buyers enthusiasm for higher bids and prevents the price from falling further. The resistance level attracts the sellers enthusiasm for shorting. It prevents the price action from advancing higher. The crowd likes to trade the breakout. The idea of trading breakouts appeals to many independent traders especially those new to currency trading. It is perfectly logical for the crowd to think that if the support level is penetrated, then the price action should move downward. The crowd is more likely to sell than to buy.
The opposite is true of a price break above the resistance level. The crowd usually concludes that if the resistance is broken, then the prices are more likely to advance higher in the rally. Hence, the crowd is more likely to buy than to sell. You will find clusters of stop loss orders placed by traders who have brought near the support level or have sold near the resistance level. Now you can also understand why there tends to be large number of entry stop orders placed just above a resistance level and also placed just below a support level.
Short positions will be stopped out when the price action breaks out above the resistance level. Similarly, when the currency prices crosses below the support level, long positions will be stopped out. You will ask why most breakouts fail? The fact that smart traders need to take the money from the novice and inexperience traders is one of the most important reasons why most breakouts fail. Always remember, it does not always pay to have the same mentality as the crowd. The majority will cash out of the trading game broke.
The crowd holds the dumb money with the weak hands. Smart money belongs to the big players who have a couple of tricks to sabotage the crowd. Money has to be made from the majority. Not from the minority who got it right. When the crowd scrambles to get out of their losing positions, it causes vertical rallies or declines. The most money is made when the crowd turns out to be wrong. If there is much market demand to buy above a resistance level or sell below the support, the forex broker acting as the market maker has to absorb all the buy/sell orders. However, you must know that the market maker is not a fool. There must be a seller for each buyer and a buyer for each seller.
Most of the retail traders being inexperienced or new like to trade the breakouts! When the new traders learn technical analysis, they tend to most eagerly follow trade recommendations based on certain chart patterns recommended in the books. However, the seasoned traders prefer to fade breakouts. They do exactly the opposite of what the crowd is expected to do. Most of the successful traders have contrarian trading approach. Trading is a zero sum game. For every loser, there is a winner. Most of the breakouts fail. Breakouts fail because the institutional or the seasoned traders take advantage of the crowd psychology of the retail or inexperienced traders and win at their expense.
Lets understand the tricks that can be played by the institutional dealers and traders. Their game plan is simple. Market markets mostly the forex dealers and brokers can fade breakouts. They will make money from the majority of the crowd who thinks that prices will rally happily after an upside breakout. Similarly, it will decline dangerously after a downside breakout. Market makers are the pricing counterparties to the retail traders like you and me. They have to take the opposite side of your trade whether you like it or not. Suppose most of the retail traders have placed their stop entry order at a certain price above the resistance level.
Market makers reach into their pockets. They spend some of their money to bid up the price to that level where most of the stop entry levels have been placed. Now they can sell to most of the traders who are desperate to buy. Thus making some decent profits from this trick played on inexperienced traders. By selling to the retail crowd, market makers get the chance to close their long positions. Now they begin to overwhelm the buying crowd by going short. This pushes the prices down, below the breakout level. However, you should not misunderstand every false breakout as the result of the tricks big players play. False breakouts can be as a result of price action losing momentum soon after a breakout. Market running out of steam to reach higher highs and lower lows in a sustained price break may also give you a false breakout.
This can happen when there are not enough buyers in the market to sustain an upward price move or not enough sellers in the market to sustain a downward price move. Since the big players like to fade breakouts, individual traders have higher chances of success if they also fade the breakout. Profits potential in price breakout is far higher than in a failed breakout. Everyone wants big easy profits. Fading breakouts is counterintuitive and it is not something instinctive. The question is how to identify a false breakout.
Look for fading breakout opportunities on a minimum time frame of hourly charts or more. Fading breakouts can occur anywhere on the price charts at the levels of support and resistance. The price will bounce off the trendline in a false breakout. Trendlines are drawn by joining at least two extreme points of highs or lows over a long period of time. Probability of a false breakout is higher if the trendline is at an angle or a gradient.
Usually the third or even fourth extreme point of contact on a gently sloping trendline presents a good fading opportunity. The chances of this fading breakout are more if the moving average lies slightly below the ascending trendline or slightly above the descending trendline. The speed of price movement before the approach to the trendline should also be considered. If the prices are approaching the trendline slowly and gently, the chances of a false breakout or a trendline bounce will be much higher. The fast and high amplitude approach will most likely result in a successful price breakout of the trendline on the other hand. There will be a sustained follow through in prices due to the high momentum. In such a case, dont trade it as a likely false breakout.
You will want to know how to trade a fading breakout? You should place a limit or market entry order a few pips below a down trendline or above an up trendline. You can stagger your entry orders by placing another order a few pips away from the breakout if you are an aggressive trader. Now there are a few chart patterns that are ideal for identifying the false breakouts. You should read the next part of this article for more on those chart patterns. About placing staggered entry orders for fading breakouts, you should do it with a proper money management plan. Stops should be placed at least 20-30 pips beyond the support or resistance, away from the price zone. This will make your average cost of entry more favorable for either your long position or your short position. There are some technical formations where the false breakouts are more likely to occur in the currency price charts. You should be able to identify likely false breakouts in order to employ the breakout fading strategy. You need to apply a lot of common sense in identifying a false breakout.
Head and Shoulders Pattern
The head and shoulder pattern consists of three points of rallies. The pattern resembles the head and shoulder pattern of a human. The middle rally is the highest with the left and right being smaller. This chart pattern is the hardest for new traders to identify. Dont confuse it with a shampoo. A neckline can be drawn connecting the lows of the left and right shoulders. It signals a bearish reversal or a consolidation period before the uptrend is continued if the head and shoulder pattern is found at the end of an uptrend. An inverted head and shoulder pattern can also be found in the middle or end of a downtrend. The head and shoulder pattern is usually found in the middle or end of an uptrend.
If they are buying up the rallies from the support level, many traders who have identified the head and shoulder pattern as a possible breakout signal place their stop loss orders below the neckline. Head and shoulder patterns are notorious for precipitating a false breakout. Similarly, if traders are shorting the decline from the resistance level, they place their stop loss orders above the neckline of the inverted head and shoulder pattern. Traders can also place numerous entry stop orders below the neckline. Traders can also place entry stop orders above the inverse neckline in anticipation of a breakout besides the stop loss orders.
False breakouts are triggered by the market makers to shake out the positions of small traders most of the time. Prices will usually rebound. There maybe explosive price movements off the neckline in the pre breakout zone. It is always best to assume that the first break of a head and shoulder pattern tends to be false. You may choose to place a stop loss slightly below the high of the second shoulder or slightly above the low of the second shoulder. You may fade the breakout with a limit of market entry order a few pips above the neckline or a few pips below the inverse neckline.
Double Top and Double Bottom
A double top formation consists of two rally peaks separated by a valley. The two peaks need not be of the same height. A double bottom is simply an inverted image of a double top. The problem with this chart pattern is also this that it is used by novice traders as a signal for possible breakout. Using this chart pattern as an indication for a likely breakout makes these traders easy bait for the big players. Fading breakout is more effective in range bound markets. The breakout fading strategy usually does not work well when the market is in a strong trending phase.
Hassam 
