Chapter 13
Technical Trading Strategy: Fader

More often than not, traders will find themselves faced with a potential breakout scenario, position for it, and then only end up seeing the trade fail miserably and have prices revert back to range trading. In fact, even if prices manage to break above a significant level, a continuation move is not guaranteed. If this level is very significant, we frequently see interbank dealers or other traders try to push prices beyond those levels momentarily in order to run stops. Breakout levels are very significant levels and for this very reason, there is no hard fast rule as to how much force is needed to carry prices beyond levels into a sustainable trend. Trading breakouts at key levels can involve a lot of risk and as a result, false breakouts appear more frequently than real breakouts. Sometimes prices will test the resistance level once, twice, or even three times before breaking out. This has fostered the development of a large degree of contra-trend traders who look only to fade breakouts in the currency markets. Yet fading every breakout can also result in some significant losses because once a real breakout occurs, the trend is generally strong and long-lasting. So what this boils down to is that traders need a methodology for screening out consolidation patterns for trades that have a higher potential of resulting in a false breakout. The following rules provide a good basis for screening such trades. The fader strategy is a variation of the “waiting for the real deal” strategy. It uses the daily charts to identify the range-bound environment and the hourly charts to pinpoint entry levels.

Strategy Rules

Longs:

  1. Locate a currency pair whose 14-day ADX is less than 20. Ideally, the ADX should also be trending downward, indicating that the trend is weakening further
  2. Wait for the market to break below the previous day's low by at least 15 pips.
  3. Place an entry order to buy a few ticks above the previous day's high.
  4. After getting filled, place your initial stop no more than 20 pips away.
  5. Take profit on half of position when prices increase by the amount you risked; move stop on remaining position to breakeven.
  6. Trail the stop on the remaining position.

Shorts:

  1. Locate a currency pair whose 14-day ADX is less than 20. Ideally the ADX should also be trending downward, indicating that the trend is weakening further
  2. Look for a move above the previous day's high by at least 15 pips.
  3. Place an entry order to sell a few ticks below the previous day's low.
  4. Once filled, place the initial protective stop no more than 20-pips below your entry.
  5. Protect any profits by selling half of the position when it runs 20 pips in your favor.
  6. Place a trailing stop on the remainder of the position.

Examples

Let's start by taking a look at an example to the short side. Figure 13.1 shows a daily chart of USDJPY with the ADX below 20 and pointing downward. This is the first signal that a trade setup is in place. In this example, the previous day's high is 120.27. We first look for a move above the previous day's high by at least 15 pips, or 120.42. As shown in Figure 13.2 the hourly chart, that move occurs at the start of the European session after which we place an order to sell 5 pips below the previous day's low of 120.00. The order is filled a few hours later at 119.95. At the time, we place our stop at 120.15 and a first target of 119.75. The first target is reached, and the stop on the rest of the position is moved to breakeven or 119.95. In this example, the second half of the trade remains live and will either be closed at breakeven, or the stop will be trailed.

Image described by surrounding text.

Figure 13.1 USDJPY Daily Chart

Source: eSignal

USDJPY 60-minute candlestick chart, with arrows pointing the high broken, low broken, and first taget hit stop moved to breakeven. The candlesticks end at 19.850.

Figure 13.2 USDJPY 60-Minute Chart

Source: eSignal

Now let's take a look at an example to the long side. Figure 13.3 shows a daily chart of EURUSD with the ADX below 20 and pointing downward. This is the first signal that a trade setup is in place. In this example, the previous day's high is 1.0801, and the low is 1.0708. We see that the low is broken first, and when that happens we place an order to buy 5 pips above the previous days high at 1.0806. As shown in Figure 13.4, the order is triggered about 7 hours later. At the time, we place our stop at 1.0786 and a first target of 1.0826. The first target is reached shortly after, and the stop on the rest of the position is moved to breakeven, or 1.0806. In this example, if we trail the stop on the position using a two-bar low, the second half of the trade is closed at 1.0818.

EURUSD daily candlestick chart with a curve depicting ADX < 20. An arrow pointing at the second candlestick to the last is labeled trade opportunity.

Figure 13.3 EURUSD Daily Chart

Source: eSignal

EURUSD 60-minute candlestick chart with horizontal lines marking the previous high and previous low and arrows labeling entry and first target hit.

Figure 13.4 EURUSD 60-Minute Chart

Source: eSignal

Further Optimization

The false breakout strategy works best when there are no significant economic reports scheduled for release that could trigger sharp unexpected movements. For example, prices often consolidate ahead of the U.S. nonfarm payrolls release. Generally speaking, they are consolidating for a reason, and that reason is because the market is undecided and is either positioned already or wants to wait to react following that release. Either way, there is a higher likelihood that any breakout on the back of those releases would be a real one and not one that you want to fade. This strategy works best with currency pairs that are less volatile and have narrower trading ranges.