What is a Fakeout in Technical Analysis and How to Spot One

What Is a Fakeout?

Fakeout is a term used in technical analysis to refer to a situation in which a trader enters into a position in anticipation of a future transaction signal or price movement, but the signal or movement never develops and the asset moves in the opposite direction.

Understanding Fakeouts

A fakeout can cause considerable losses for a technical analyst. These investors will typically rely on well tested patterns, multiple affirmations of an indicator and specific allowances to protect from significant losses. Sometimes the setup can look perfect, but outside factors can cause a signal to not develop as planned.

Common Indicators

Technical analysts typically follow multiple patterns on a single technical chart to provide for various affirmations in determining a trading signal. Envelope channels are one of the most reliable trading channels that an investor will use to track the movement of a price pattern over a long-term time-frame. These patterns draw a resistance and support trend-line which forms a channel that can help to identify the broad trading range that a security price is likely to stay within.

There are several envelope channels that an investor can use to form a channel pattern for range indicators. Some channels are more reliable than others with Bollinger Bands being the most popular charting channel.

While prices typically have a tendency to remain within their banded range, they may often breakout above and below the resistance and support lines which can lead to a potential fakeout.

Trend channels can also be a popular pattern with a potentially higher risk than envelope channels. These channels only focus on a security’s short-term trend and do not encompass reversals. Trend channels will go through a cycle with a breakout, runaway and exhaustion gap. Detecting an exhaustion gap and potential reversal can present high risks of a fakeout since it can be difficult to know with certainty when a reversal is occurring.

Multiple Variables

Since fakeouts can cause significant losses, traders will typically use multiple variables in their analysis before execution. In addition to a security’s price drawn through candlestick patterns and price channels, investors may also look at other variables. Two other common variables that can support price changes include market breadth and volume. The McClellan Oscillator trendline can be a helpful overlay for considering market breadth. Volume is also often a key variable that can add affirmation to a trading signal.

In addition to charting volume levels, indicators such as the volume weighted average price trendline, the Positive Volume Index and the Negative Volume Index can also be helpful. Traders can also use market news as well as qualitative and quantitative research to support investment trades.

Regardless of the indicators used, technical analysts will often encounter fakeouts. To mitigate the risk of fakeouts many technical analysts typically deploy limits on the total value of their investment that they bet for each trade. A common limit for investment trades is 2% of portfolio risk. Technical traders will also typically set stop loss orders on trades at a specified level to ensure that losses are managed if they do occur. The idea here is to be prepared for any potential outcome prior to putting on a trade.