A head-fake trade occurs when a security’s price moves in one direction only to reverse course and move in the opposite direction. Much like an athlete’s deceptive maneuver to confuse opponents, a head-fake move misleads traders before revealing its true intention. This phenomenon is frequently seen at key breakout points, such as major support or resistance levels, or near significant moving averages like the 50-day or 200-day simple moving averages (SMA).
Key Insights
- Directional Reversal: The price initially moves against the trend but then realigns with the overall trend.
- Breakout Zones: Common at critical support or resistance points and near key moving averages.
- Stop-Loss Triggering: Often occurs due to stop-loss selling or buying at these levels.
- Potential Losses: Can lead to significant losses if misread, occurring just before a major trend direction.
Deconstructing a Head-Fake Trade
Imagine a well-known market index surges to new highs despite weakening economic indicators. Traders eager to short the index will vigilantly track essential technical levels for signs of a breakdown. Suppose the index’s ascent stalls and dips below a fundamental short-term moving average. This movement might entice short-sellers thinking the decline has begun. However, if the index then rebounds and surges higher, this movement is known as a head-fake trade.
Contrarian investors thrive on these scenarios as their strategies are built around countering the majority opinion. They believe institutional traders drive prices through clearly monitored support/resistance levels to discover additional liquidity, securing better prices for sizable client orders.
Traders or investors caught in a head-fake can face considerable losses, highlighting the necessity of diligently adhering to stop-loss orders to mitigate risk.
Breakouts and Head-Fake Trades
Following an initial breakout, some level of pullback is typical. As the price retraces to the original breakout or slightly further down, traders must discern if it signifies a head-fake—a false breakout—or a temporary pause before resuming the trend. A pullback might serve as an opportunity to enter the breakout at a more favorable level.
Real-World Example of a Head-Fake Trade
In 2022, the U.S. dollar experienced a significant surge against most currencies. Analyzing the USD/HUF (U.S. dollar vs. Hungarian forint) revealed numerous pullbacks contained by a dominant rising channel, except for one instance where the price dropped below a key uptrend support line but reclaimed it by day’s end.
This scenario illustrates a classic countertrend, head-fake pattern. A trading decision based on the trendline break would quickly show that the break was false—a head-fake price movement. Tight stops or observing that the USD-HUF pair returned inside the dominant upward channel by the day’s end would indicate a head fake, particularly since there were no fundamental changes to support a USD weakening.
Determining If a Price Move Is a New Direction or Just a Head Fake
Head-fake trades typically last a short time, often an hour or a day. If a price move coincides with breaking a key technical level but then regains that level, it’s likely a head-fake move. Therefore, maintaining tight stop-loss orders when following a price break is crucial to avoid getting caught in a head fake and missing out on continuing the earlier trend.
Causes of Head-Fake Price Movements
Head-fakes usually test significant technical support or resistance like trendline support in an uptrend or essential moving averages. Trading at these levels may trigger stop-loss orders, creating temporary buying or selling pressure. If technical levels are reclaimed shortly afterward, it indicates a head fake or false break.
How Much Risk to Take on Potential Head-Fakes
Since a head-fake trade defies trends, employ tight stop losses to protect against potential reversals. Risking a quarter to half of your normal position is reasonable for head-fake setups, balancing the conservative risk with the breakout trade’s opportunity while minimizing potential losses.
Final Thoughts
Head fakes involve false breakouts at critical technical levels that can catch the market off guard, leading to substantial price movements. They are common at pivotal technical junctures and represent counter-trend breakouts. Evaluating the duration and magnitude of the price break against key levels is essential in deciding whether it’s a genuine breakout or a head fake. Consider any new information or lack thereof to differentiate between legitimate countertrend moves and head-fake scenarios. Being strategic with your stop-loss orders and cautious with your risk can help you navigate these deceptive market moments adeptly.
Related Terms: breakout, false breakout, stop-loss, trendline support, pullback.
References
- Detroit Advisers. “Head-Fake Trade”.
