Breakout Trading and Fakeout Trading in Forex
Breakout and fakeout trading enable traders to take positions in rising and falling markets. When a trend is at its early stages, you can use breakouts to find ideal entry positions in the market. Whereas, fakeout can be used to plan exits. In our article, we take a look at everything about trading breakouts and fakeouts.
What are breakouts?
Breakouts occur when a currency pair’s price moves above its resistance level or below its support level. Post a breakout situation, the currency pair prices start trending in the same direction.
- When there is a breakout in the upward direction, beyond the resistance level, it signals traders to place buy/long orders as prices are expected to rise further
- When there is a breakout in the downward direction, below the support levels, it signals traders to place sell/short orders as prices are expected to fall further
What are fakeouts?
Fakeouts occur when a trader enters a market position with a specific market trend expectation, but the trend never forms. It in turn depicts a false signal and currency pair prices move in the opposite direction instead. This happens when a currency pair has a strong tendency to trade within their price range between the support and resistance levels but breakout temporarily, leading to a potential fakeout.
- During a fakeout, when the prices move beyond the resistance level and follow a temporary uptrend, the fakeout leads to a drop in prices soon after and signal traders to short a trade
- During a fakeout, when the prices move below the support level and follow a temporary downtrend, the fakeout leads to an increase in prices soon after and signals traders to long a trade
How do you trade breakouts?
1. Identify the support and resistance price levels
Identify the support level where the falling prices stop falling and start increasing, and the resistance levels where the rising prices stop rising and start decreasing. The support and resistance levels will act as the two extreme points beyond which a breakout will occur.
- Prices falling below support will lead to a breakout
- Prices rising above resistance will lead to a breakout
2. Measure the distance between the current price and support/resistance levels
The closer the market price is to the support or resistance level, the stronger the breakout is. For example, if the current market price is close to the resistance level, it indicates a breakout beyond the resistance level in an upward direction. If the current market price is close to the support level, it suggests a breakout below the support level in a downward direction.
3. Trade the breakout
The prices fluctuating near the two levels provide a breakout signal, which is confirmed when the candlestick closes above the resistance level or below the support level.
How do you trade fakeouts?
1. Measure distance between the price and S&R levels
A potential fakeout signal is generated whenever the currency pair prices close far away from the resistance or support level. The greater the distance between the price and S&R level, the higher the chances of a strong potential fakeout.
2. Measure the candlestick’s wick size
The size of the candlestick’s wicks indicates the fakeout’s strength. The smaller the wick, the lesser the chances of a potential fakeout and the larger the wick, the higher the chances of a fakeout. When the upper wick (or lower wick) of a candlestick is long, it indicates that there is a significant difference between the high (or low) price and close (or open) price level of a currency pair, leading to a potential fakeout.
3. Measure the size of the candlestick
The size of a candlestick depicts the difference between their closing and opening prices. When long candlesticks are in the breakout’s opposite direction, it indicates a fakeout due to the market contradiction. Breakout in any position supported by a candlestick in the opposite direction leads to a strong fakeout signal.
Trading techniques to trade breakouts and fakeouts
Pullback Fibonacci levels
During a breakout, the pullback support level is formed at the Fibonacci levels as a strong breakout continuation signal.
Trend lines can be used to spot breakouts right when a currency pair price action is pushing beyond or below a strong market level.
Candlesticks in a higher time frame provide traders with the trend’s strength and enables them to take entry or exit positions accordingly. If the traders are not sure about the breakout occurring, waiting for a higher time frame candlesticks confirms the breakout analysis.
If a chart pattern continues in the same direction after a breakout, it suggests traders that there is not going to be any move against the breakout. It confirms the trend continuation and enables traders to take orders accordingly.
The Ichimoku indicator confirms a breakout whenever it occurs below or beyond the bullish or bearish market trend.
Elliott Wave Theory
The Elliott Wave Theory helps traders analyze current and historical price swings to analyze the future price swings. After the traders make a market forecast, they can evaluate the strength of the breakout based on the anticipated future price trend.
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