indicators or along trendlines, are an indication of where a predictable price
response can be expected. A support level is where buying pressure overwhelms
selling pressure enough to interrupt or reverse a downtrend. A sturdy support level
is more likely to hold up even if prices slightly pierce through the support, and that
presents traders with an excellent buying opportunity.
Conversely, a resistance level is where selling pressure is strong enough to
overcome buying pressure such that an uptrend can be stopped temporarily or
reversed. A strong resistance level is more likely to block further advance even if
prices slightly pierce through the resistance, and such a situation presents traders
with an excellent shorting opportunity.
You can take advantage of such opportunities by fading breakouts.
Fading breakouts refers to trading against breakouts, when you believe that the
currency prices will not be able to sustain a follow-through action in the direction
of the breakout. We fade breakouts when we expect breakouts from support and
resistance levels to be false and unsustainable, especially when those support and
resistance levels are of great significance. Many breakouts tend to fail at the first
few attempts, and that makes fading breakouts an excellent short-term strategy for
forex traders. Fading breakouts tends to be more effective as a short-term strategy,
and is not meant for the long-term. False breakouts, also known as fakeouts, are a
bane for breakout traders, but boon for breakout faders.
The Crowd Likes to Trade Breakouts
The idea of trading breakouts appeals to many independent traders, especially
newcomers to the currency market. Support and resistance levels are seen as price
floor and price ceiling respectively. A support level attracts buyers’ enthusiasm for
higher bids, and prevents the price from going lower, while a resistance level
attracts sellers’ enthusiasm for shorting, and prevents the price from advancing
higher. Thus, it is perfectly logical for the crowd to think that if the support level is
penetrated, then the general price move should be downward, and hence they are
more likely to sell than to buy. The opposite is true for a price break above a
resistance level.When that happens, the crowd will usually come to the conclusion
that if the resistance level is penetrated, then prices are more likely to advance
higher in a rally, and hence they are more likely to buy than to sell.
Knowing this, it is very easy to see why there tends to be a big cluster of entry stop
orders placed just above a resistance level and also placed just below a
support level.
However, the cluster of stop orders there does not just comprise entry orders, but
also stop-loss orders placed by traders who have bought near the support level, or
have sold near the resistance level. So if the currency price crosses above the
resistance level, short positions will be stopped out. In an opposite fashion, long
positions will be stopped out when the currency price crosses below the
support level.
Why Most Breakouts Fail
One of the most compelling reasons why most breakouts tend to fail is due to the
fact that winners need to take money from losers, and it does not always pay to have
the same mentality as the crowd, as the majority will crash out of the trading game
broke. Money has to be made from the majority, not from the minority who get it
right. The crowd holds the dumb money with weak hands, whereas the smart
money tends to belong to the domain of big players who can afford to reach into
their deep pockets for a couple of tricks to sabotage the crowd. The most money is
made when the crowd turns out to be wrong, because then these players will
scramble to get out of their losing positions, causing vertical rallies or declines.
If almost everyone, ranging from people hanging out in online forums to your
neighbours, see the same great opportunity to buy above a resistance level or sell
below a support level, who will be the sellers on the other side of the transaction?
For someone to buy something, there must be a seller, and vice versa. Granted,
there are not too many traders who are indeed unaware of such a level, so how can
the majority make money from the minority? If there is so much market demand to
buy above a resistance or sell below a support, the market maker has to absorb all
those one-sided orders and take the other side of the equation. However, we must
be aware that the market maker is certainly no fool.
Trading against the crowd
I have increasingly noticed that obvious support and resistance levels on the
currency price charts tend to provide the best opportunities for fading breakouts,
although it is not always the case. This is not surprising, given the fact that the most
well-recognised price levels or chart patterns will be detected by the majority of
traders. Almost everyone is taught the same aspects of technical analysis from
books or other sources, and new traders are the ones who tend to most eagerly
follow trade recommendations stemming from the formation of certain chart
patterns on the currency price charts.
Retail traders like to trade breakouts, but institutional, or the more seasoned traders,
prefer to fade breakouts, doing exactly the opposite of what the majority is
expected to do. That is one of the main reasons why most breakouts fail – the
institutional or seasoned traders taking advantage of the crowd psychology of the
retail or inexperienced traders, and winning at their expense. Our strategy is to trade
in the direction of institutional activity, by fading breakouts.
Source: 7 Winning Strategies for Trading Forex: Real and Actionable Techniques for Profiting from the Currency Markets
