What Is a Fade?
Fade refers to a contrarian investment strategy used to trade 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.
A less common use of the term fade refers to the failure of a dealer (market maker) to honor a published quote when a customer or another dealer wants to trade.
- Fading is a contrarian strategy, where traders take an opposite position into a high-momentum trend.
- A market maker or dealer who does not stand on their bid or offer for very long may also be said to fade their markets as prices turn against the original bid-ask.
- Forex traders will often adopt a fade strategy in light of major economic news releases.
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 is mostly powered by traders who have been slower to react, thus increasing the probability of a reversal of the initial thrust.
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 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.
Another example of a fade strategy would include buying on a dip in price and selling when prices rally. 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. 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 he or she believes the market has overreacted. Investors who use fade strategies, often get referred to as "contrarian investors.”
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 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.