Introduction to Technical Analysis: “Morning Fake-out”

Posted: 08 May 2011 02:19 PM PDT

As regular readers of this blog are probably aware, I rarely post about technical analysis. Simply, I’m not well-acquainted with its nuances, and I would probably sound like a dilettante if I tried to offer some serious advice on the subject. That being said, I read an interesting overview of a particular technical strategy (in the San Francisco Gate, of all places…please hold your laughter), that appealed to me on a number of levels, and that I would like to to share below.

Contrary to popular belief, the forex market is not a 24-hour market. Given time differences and market overlap, it’s true that it’s possible to trade forex 24 hours a day, six days a week. In practice, however, the markets are observably more active/liquid at certain regular hours. Anecdotally, it seems that many traders focus their trading at these hours, since the opportunities for profit (and losses, to be fair) are greatest at these times.

The author of the article (Investopedia contributor Cory Mitchell) has specifically identified the opening of certain key markets (typically 9AM local time; actual time will vary based on your location). Prior to opening, the markets may appear calm before a sudden onslaught of trading activity, as banks move to establish new positions for the day, stop orders are cleared, and the market struggles to find direction. In every major market, there are a handful of currency pairs that dominate trading in that market, and that traders should pay special attention to at the open. Tokyo has the Yen; London has the Pound, Euro, and Franc; New York has the US Dollar.

This confusion may create an opportunity if a so-called “fake-out” occurs. Basically, the market will suddenly lurch in one direction, and trading desks might latch (mistakenly) onto this pattern with the goal of reaping early morning profits. In some cases, this break-out will just as quickly reverse course, and a dominant trend will re-establish itself. Those who have correctly anticipated this can enter the market in the direction of the dominant trend and ride the wave in that direction as it entrenches.

I like this strategy because I think it is grounded in human psychology. Basically, it speaks to early-morning overzealousness by poor traders that is quickly overcome by broader market forces, which will re-assert themselves when opportunity resurfaces. Of course, the market is zero-sum, which means that all profits are necessarily earned at the expense of those caught trading what in hindsight was a false breakout.

Of course, trading the morning fake-out is hardly this simplistic, and those that are curious to learn more would be wise to read the original article. Still, I think it offers a few convenient lessons for aspiring technical traders, and even for fundamental traders with shorter time horizons. First, understand that the market is inherently busier at some times of the day than others. Second, understand that while the trend is still your friend, there are micro-trends which may be moving in the opposite direction from the macro-trend. Third, make sure to establish stops, so that if you are unlucky enough to get caught trading in the direction of the fake-out, your losses are limited. Finally, it’s worth remembering that the forex market is inherently zero-sum. While an overall bear market is categorically impossible, so is an overall bull market. That means that any profits you earn must be at the expense of unskilled/unlucky traders. The only way you will come out ahead is if you are not one of them!

Newsflash

Sunday, May 8, 2011

Introduction to Technical Analysis: “Morning Fake-out”

Introduction to Technical Analysis: “Morning Fake-out”

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