Fading the Fakeout – How to Trade Against False Breakouts
Unless there’s some change in fundamentals, asset prices don’t tend to change that quickly that often. But sentiment perpetually swings from fear to greed as information and disinformation filter through.
The noisy blips even out over time, and when markets are liquid enough they tend to find their fair value.
Fading is a strategy that exploits these blips in price. The fader bets against any move that takes the price out of a normal range. Another way of putting it is that fading is a bet on mean reversion.
This strategy shouldn’t be confused with trading against the trend. The experienced fader only trades at times when the price breaks into uncharted territory.
Fading has some good logic behind it. Anyone who’s tried a breakout strategy will know how challenging it can be.
Too many breakouts don’t work out the way you expect them to. Many breakouts that start off strongly quickly fade and start to track back into a range. False breakouts are so common they even have their own name. Fake outs.
The profits to be made from a fading strategy may not be huge. But nevertheless it can be rewarding if you know how to do it well. This is because fading tends to have a high win rate. That makes it a good area for specialization.
How to Fade an Early Channel Breakout
When a breakout starts, there’s one of two things that will happen. Either the price breaks out of the existing channel and starts on a new trend. Or it reverses and the price dives back into the existing channel. Often times, the existing channel is the comfort zone.
Therefore to know when a breakout happens you need to first define where the normal range is. To do this, support and resistances, pivot lines, Bollinger bands and moving averages are the obligatory tools.
The Bollinger band channel is very useful here because it gives the average of the price as well as an envelope that represents its volatility. That is its range of statistically probable movements.
The chart above demonstrates with two Bollinger bands, each with a period of 20 bars. To define the channel, set the first Bollinger envelope so that it encloses about 95% of the latest price history. On the Bollinger indicator this should be somewhere between about 1.8 and 2 standard deviations.
Next place a second Bollinger band on the chart with a slightly wider envelope. This should be about 0.5 to 1 standard deviations higher than the inner band.
Fading the Breakout
The fading technique is to average into the position when the price lies at the extremes in the envelope. Then close when it returns towards the mean line which is the profit target.
This way you trade against early breakouts on the expectation that the price will, most times, revert back to the mean.
Decide on a maximum order size in line with your risk tolerance. And then divide that by the number of fills you will use. With 1 lot and 3 fills for example, each fill will be 0.33 lots in size.
Then for a long, buy when the price falls between the lower two bands. Or go in short whenever the price is between the upper two bands.
For long and short, average into the position up to the maximum position size. The table below shows one complete trade, also annotated on the chart above.
|Fill #||Side||Entry Price||Size|
Because channel fading is a mean reversion strategy, averaging into and sometimes out of the position is a necessary part of it. These orders are placed roughly 10 pips apart but this is adjusted up or down depending on the volatility. With higher volatility increase the interval between each fill and with lower volatility, decrease it.
Wait for the price to move back towards the mean before taking profits. In the chart the price moves back to the middle line where the profit is taken by selling to close at 9.4638. The trade returns a small profit of 11.3 pips.
If the price doesn’t revert back quickly, it’s best to close, on a loss if necessary, rather than wait. If the price stays at the extreme edges of the envelope for long the Bollinger band will start to adjust to that trend as the new normal. This means a loss could be realized when the price does eventually return back to the middle line.
Scalp fading is a strategy that trades against very short term price action, usually within the time of a single bar. It relies more on intuition than on any mechanical rule set.
Firstly if the bar opens above or below the close of the previous bar creating an opening gap, the fader bets against that on an assumption that the price will revert back within range during that time interval.
Or if the open to close range pushes the price too far, too quickly, the scalp fader bets on a pull back towards the mean. Big jumps in price will happen, but not very often.
In the chart above, a breakout starts at the candle labelled (1). Even if the breakout succeeds, as it does here, the fader bets on some price elasticity. The strategy is to sell at the open of the next bar assuming the price will pull back to within range again. The price does fall and it takes back about half of the advancement of the earlier bar.
The second candle, (2) opens high above the close of the previous creating an opening gap. The fader bets on that gap being closed and sells at the open. The gap duly closes, and price falls back on a less extreme path.
As shown above, scalp fading is betting on short-term price elasticity, or put another way a bet on price extremes being levelled out.