A fakeout is a term used in technical analysis (TA) that refers to a situation where a trader enters a position expecting a price movement that ultimately doesn’t happen. In fact, in most cases, a fakeout is used to refer to a situation where the price goes in the opposite direction of the trade idea or signal.
A fakeout may also refer to a “fake breakout,” or false breakout, where price breaks out of a technical price structure, only to reverse shortly.
A fakeout can amount to a considerable loss. Technical analysts may identify a pattern that fits perfectly with their strategy, and looks to be playing out as expected. However, the price may reverse very quickly due to outside factors, and the trade can quickly turn into a hefty loss. As such, in anticipation of a fakeout, many traders will plan their exit strategy and put on stop-loss orders in advance of entering trades. In fact, this is quite a common strategy for basic risk management.
To mitigate the risk of fakeouts, many traders will limit the amount of capital they risk in a given trade. As a general rule of thumb, many won’t risk more than 1% of their trading capital in a single trade. So does this mean that they enter a given position with only 1% of their capital? No. It only means that if the market reverses and their stop-loss is hit, they will only lose 1% of their trading capital in a single position.
Another strategy that helps mitigate the potential effects of a fakeout is relying on multiple technical indicators to enter a trade. Technical analysts may set very rigorous requirements for what constitutes as a trading signal in their strategy. If one indicator is giving off a signal, it may not be a signal to buy or sell in itself. However, if multiple indicators are saying the same thing, it may confirm the strength of a signal. Even so, there are no guarantees when it comes to the financial markets, and the strongest looking signal can also turn into a fakeout.