What Is a Head-Fake Trade?
A head-fake trade is when a security's price makes a move in one direction, but then reverses course and moves in the opposite direction. The head-fake trade gets its name from a tactic commonly used by a basketball or football player to throw the opposition off, by leading with their head to pretend that they are moving in one direction but then move in the opposite direction. The head-fake trade occurs most frequently at key breakout points, such as major support or resistance levels, or closely watched moving averages like the 50-day or 200-day simple moving average (SMA).
- A head-fake trade moves in one direction, but then reverses course and moves in the opposite direction.
- Head-fake trades occur most frequently at key breakout points, such as major support or resistance levels, or closely watched moving averages.
- Head-fake trade can lead to significant losses as they often occur before the start of a major trend in the opposite direction.
Understanding a Head-Fake Trade
Consider a situation where a major market index has made new highs amid deteriorating economic fundamentals. Traders who are looking to short the index will closely monitor significant technical levels to assess whether the advance is beginning to break down. Suppose the index advance stalls and begins to drift lower, trading below a key short-term moving average. The bears might rush in at this point, based on their trading view that the index decline has begun, but if the index subsequently reverses course and heads higher, this would be a classic head-fake trade.
Contrarians often try to profit from head-fake trades, since their trading philosophy embraces a willingness to go against the crowd. They argue that institutional traders push a security's price through closely watched support/resistance areas to find additional liquidity to fill larger orders at a better price for their clients, particularly in the foreign exchange market, which doesn’t have a centralized regulator.
Traders and investors who fall for a head-fake trade can incur significant losses as they often occur before the start of a major trend in the opposite direction. Adherence to strict stop-loss limits in such cases helps to minimize risk.
The Head-Fake Trade and Breakouts
An initial breakout is typically followed by some level of pullback. As price retraces to the original breakout level or somewhat further, the trader is left to determine whether the pullback is the beginning of a head fake—a false breakout—or whether it is temporary, and the market will soon continue in the direction of the breakout. In the latter case, the pullback may present another opportunity to enter a breakout move.
Flash Crash Head-Fake Trade
The record bull market that commenced in March 2009 has produced many head-fake trades over the past decade. Perhaps the best-known example was the "Flash Crash" of May 6, 2010, in which the Dow Jones Industrial Average (DJIA) plunged almost 1,000 points in a matter of minutes in intra-day trading before erasing most of that loss by the close. Traders who put on long-term bearish bets on U.S. equity indices, based on the view that the "Flash Crash" portended a new bear market, suffered the pain of seeing these indices go on to record highs in subsequent years.
Head-Fake Trade Practical Example
The PayPal Holdings Inc. share price staged a textbook head-fake trade on June 3, 2019, plunging below both the 50-day SMA and May 13 swing low—a key support area. The stock’s price rallied 3% on the following trading day to close back above the support area, giving the first clue of a possible head-fake trade. PayPal shares continued to move higher in subsequent trading sessions, with the head-fake trade confirming on June 10, when price closed above the previous swing high.