The Morning Forex Fake-Out Trade

By Cory Mitchell AAA

Many traders are aware that when a market opens there are often whipsaw-like actions (or what some may call "fake outs") before a stronger trend emerges. With currencies the market is open 24 hours during the week, therefore many traders don't see the forex market as having an "opening" session. Yet this is not true. Banks in different parts of the world open for business, and with that, a larger volume enters the market. Therefore currencies are not immune from the morning "fake out." As stop levels are cleared on either side of the open price, a stronger trend will often emerge. This trend may not last, but by knowing there is often a fake out followed by a stronger move, traders can position themselves for taking advantage if they implement the proper strategy. (For related reading, also take a look at How To Become A Successful Forex Trader.)

TUTORIAL: Forex Currencies

Opens to Watch
Not every currency's open is worth paying attention to. Ideally, traders will want to watch the most liquid currency pairs, and also look for pairs that see a large increase in volume/participants as the country/zone opens.

Because of how major market's business days overlap with one another, the European open is an ideal candidate for trading the open. One main reason for this is that pairs such as the GBP/USD or EUR/USD are not as heavily traded prior to the open, but when Germany opens followed one hour later by London at 3am EST (please be aware of impacts of daylight savings time) volume ensues. The yen is traded heavily in the Tokyo session but as London opens there is an overlap with the Tokyo session resulting in increased volatility for the GBP/JPY and EUR/JPY. The CHF/USD is also worth watching.

Therefore we have several pairs to watch starting at about 1:30 (pre-market open) till about 4am EST (one or two hours after the markets open) to watch for a set-up. Since not all signals will occur at the same time, several pairs can be traded.

The Set-Up
Prior to a major market opening, forex pairs will often move within relatively small ranges. This is not always the case though. There may be a lot of movement prior to the European open, on days such as this the set-up will be harder to see (and may not exist), therefore caution is warranted on using this strategy on such days. The set-up should be watched for on a 15 minute chart.

1. We ideally want a calm pre-market, or one that has a definable pre-market range. This range will be marked on our chart pre-market and then we will watch for the European open to begin.

2. A breakout of that range is likely to occur. We do nothing as this is quite possibly a false breakout. Ideally we want this breakout to be small, 10-30 pips (or no more than one third of the daily average range).

3. We watch for an engulfing candle pattern (or any candle which shows a strong movement in the opposite direction over one or two bars) in the opposite direction of the original breakout (for example, if the range breakout was down, we watch for a bullish engulfing pattern).

4. We make a trade in the direction of the engulfing pattern.

5. A stop is placed just below the low (high) of the bullish (bearish) engulfing pattern.

6. Profit target(s) is based on average movement during the early European session or the daily average range (trades will generally take longer to exit if using the larger daily figure).

7. Similar to a trailing stop, a new engulfing pattern in the opposite direction of our trade can be used as an optional exit. (For more on stops, see Trailing Stop/Stop-Loss Combo Leads To Winning Trades.)

Potential Issues
Before showing examples of the trades, there are several things traders should be aware of. No strategy is perfect, therefore the best outcome is to aim to maximize the good trades, and minimize the losing ones (because they will occur). Here are few guidelines which can be added to the system to aid in its effectiveness:

  • Not all signals will provide an entry and exit within the first couple of hours (see figure one). Occasionally signals will develop later in the session, and the exit may come much later. In this case a limit order can be placed for the exit, or a trailing stop used.
  • Look for a false breakout against a strong longer term trend. Trades that go with a longer term trend have a higher chance of success. Trade with the larger trend!
  • Trading multiple lots is effective, as it will allow for multiple exits. For example one lot can be exited when an engulfing pattern in the opposite direction of the trade occurs, and another exit could be placed at a rate where daily average movements indicate the trade could run out of steam. If the trade continues to run in the trader's favor, and they are still holding a position, it should be exited before the close of the European session or the U.S. session if trading in a U.S. pair.
  • If multiple entries and exits are occurring (numerous engulfing patterns in both directions) do not make more than two trades in a given direction. If a legitimate breakout has not occurred, save the system for another day.
  • If an initial breakout has momentum and runs more than 40 pips outside the pre-open range, do not make a trade in the opposite direction of this momentum even if an engulfing pattern occurs.
  • Engulfing patterns are allowed to be off by a couple pips, as long as it still shows there has been a sharp change in sentiment and direction.

TUTORIAL: Forex Trading Rules

Trade Example
Figure 1 shows a trade in the EUR/USD. A breakout lower occurred; a signal was given to enter by a bullish engulfing pattern. The trader enters long and the pair proceeds to move in her favor. The first potential exit occurs at the first bearish engulfing pattern. With an entry at 1.4074, and an exit at 1.4120 (top and bottom of engulfing bars respectively) this provides a nice gain. Potential exit number 2 is at a rate where daily averages indicate the pair may run out of steam. At this time the daily average movement was 120 pips/day. Therefore this target is placed 100 pips (always use less as the target is more likely to be hit) away from the low of the day thus far. If other signals have not occurred or the trader has a remaining portion of the position it should be exited before the end of the U.S. session. Stop is at 1.4055.

Figure 1. EUR/USD 15 Minute Chart
Source: Freestockcharts.com

Figure 2 shows a trade in the EUR/JPY and has a few differences. Our entry is similar except the candle is not an engulfing pattern, yet over two bars we see a strong upward move, erasing prior losses. We enter at 117.70. Stop is placed at 114.50. Trade moves in our direction but a strong downward move (exit 1) gets us out rather quickly with a 10 pip gain. If trading multiple lots, and the stop is not in danger the rest of the position could be exited at the close of the European session around noon EST. At this time, the daily average move was approximately 110 pips. Therefore another target could have been 90 pips above the low at 114.50, providing a target of 115.40. The market did reach this point but not till much later in the day – an order could have been placed here, and stop loss could have been moved up to Potential Exit #1.

Figure 2: EUR/JPY – 15 Minute
Source: Freestockcharts.com

Conclusion
The forex markets are open 24 hours a day, but there are still times of the day when more participants enter the markets, and these opening sessions can provide great opportunities. By watching for quick changes in direction a trader can join in on a potentially emerging trend, often with a small stop compared to the potential. No strategy is perfect, but by watching for false breakouts, reversals and using multiple exits, the trader has the potential to capture a large portion of the daily average movement.

For additional reading, also see Top Reasons Forex Traders Fail.

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