Fade: Definition in Finance, Examples, Trading Strategies

What Is a Fade?

A fade is a contrarian investment strategy that involves trading against the prevailing trend. "Fading the market" is typically a high-risk strategy and is usually deployed by seasoned traders who are cognizant of the inherent risk involved in an approach that goes against conventional market wisdom.

Another common use of the term fade refers to the failure of a dealer or market maker to honor a published quote when a customer or another dealer wants to trade. A faded quote is thus one that is not firm and subject to move against a customer.

Understanding Fades

A trader who fades would sell when a price is rising and buy when it's falling. The premise behind a fade strategy is that the market has already factored in all information and the later stages of a trend are mostly powered by those traders who have been slower to react, thus increasing the probability of a reversal of the initial thrust.

A company's fundamentals or price action, or a combination of the two, may be faded. For instance, an investor may buy a stock after a profit warning because they believe that the market has overreacted. Investors who use fade strategies often get referred to as "contrarian investors.”

Fading is typically a volatile strategy, but one which offers the potential for significant short-term gains. It requires little in the way of complicated analysis, but the risk that the trend continues is always present.

Example of a Fade

The Dogs of the Dow is a popular fade strategy that looks to relative underperforming blue-chip stocks. After the stock market closes on the last day of the year, the strategy is to select the ten highest dividend-yielding stocks in the Dow Jones Industrial Average (DJIA). Then, on the first trading day of the new year, invest an equal dollar amount in each of them. Hold the portfolio for a year, then repeat the process at the beginning of each subsequent year. 

Fading Market Makers

A market maker might, at times, ignore an order to transact at a published quote. For example, if a better bid is posted on another exchange for a security then the market maker might not be willing to match it for a client order. Instead, the market maker may offer to trade with the other market maker (with the better price). The market maker offering the better price must accept the offer and trade at the price offered or adjust the bid price.

The trade-or-fade rule is an options exchange rule that requires the market maker to either match a better bid found on another market or to trade with the market maker offering the better bid. The trade-or-fade rule was adopted in order to prevent trade-throughs, which are trades processed at non-optimal prices, as a better price is available. It was later revised to the firm quote rule.

Fading Economic News

Fading economic data is a popular forex strategy. Each week, a global economic calendar lists important economic events, such as interest rate announcements, employment data, economic activity reports, and central bank speeches. Traders who fade the economic news trade in the opposite direction of the number released. For example, if the monthly non-farm payrolls report beats economists' expectations, a trader might sell U.S. dollar pairs, such as the USD/JPY and USD/CHF, and buy pairs such as the EUR/USD and GBP/USD.

Experienced traders considered it to be prudent practice to wait a bit after a news release before entering a trade. This allows time for the larger players, and nowadays algorithmic trading models, to act on the news but still provides ample opportunity for regular traders to digest and capture the bulk of the trend if the news is faded.

Volatility is typically high for several hours after economic reports are released, so using a wider stop may help to avoid getting whipsawed out of a position.