What is Fading?
Fading involves placing trades against the trend to profit from a reversal. Using the concept of fading, a trader will short sell, expecting the momentum to fade when the market is in an uptrend. Likewise, he/she will buy a currency pair with the expectation that the move will fade away and reverse when the market is in a downtrend.
The fading strategy involves three assumptions:
- The price is either at the overbought or oversold condition.
- Early buyers or sellers are getting ready to take profits.
- Current position holders might be at risk.
Overbought and oversold conditions can be identified using technical indicators such as the Relative Strength Index (RSI). Momentum shows the signs of shifting of forces from bulls to bears or vice-versa. And as these signs develop, current holders of the asset start to rethink their positions.
These conditions get exaggerated after an earnings announcement or news release. This may lead to a knee-jerk reaction on the part of other traders to sell the currency pair. As a result, this reaction gets overextended, and a mean-reversion takes place.
Now let us see how does the strategy work and what are the necessary steps you need to take to profit from the strategy:
The Fading strategy
Step 1 – Identify market extremes from the daily time frame
The first step is identifying overbought and oversold zones using technical indicators or chart patterns.
The popular indicators used for identifying the zones include:
- Relative Strength Index(RSI)
- Swenlin Trading Oscillator (STO)
The overbought and oversold conditions are indicated by reading above or below a certain level. For example, the market is said to be in an overbought condition if the RSI is above 70, and it is said to be in oversold condition if the RSI is below 30. This can help traders in identifying fading opportunities.
In the above chart, we can see how the RSI indicator was crossing the normal range when the market gets into the overbought zone. One can find trading opportunities just using the RSI indicator stand-alone. But to trade like how professionals trade, we need to use a lot more tools.
Traders may also use familiar chart patterns or analysis based on price action and watching the price continuously.
Step 2 – Look for signs of capitulation
The second step in the strategy is to look for early signs of capitulation or change in the short-term trend using momentum. This can be mostly done by using candlestick patterns or price action with a volume indicator. We suggest looking for price action signals.
Some other signs to watch for include:
- When technical indicators start to fade or move away from their extreme overbought or oversold levels.
- The volume of the significant trend starts decreasing, or the volume of the opposite trend starts increasing.
- Bearish candlestick patterns appear (in case of an uptrend), or critical support and resistance are broken.
It’s essential to identify these signs early to maximize profit and avoid mistakes.
The signs mentioned above can be explained better with the help of some figures.
In the above image, we clearly see that the market is in an uptrend and has been trending from a few days (as it is a daily chart). The volume of the significant trend is also high with the decreasing volume of the sellers, which is a good sign for bulls. But in the end, the volume starts to decrease. The RSI declines sharply after entering the overbought zone for a while.
Immediately we see an increase in the volume of sellers with a drastic drop in the RSI indicator (Image 2). The signs are getting stronger for a reversal, and this trend can continue. All the traders who are holding the currency pair start exiting the market. This could be one of the most reliable signs for us to take appropriate action.
Finally, we see a break in the ‘support’ by the bears with high volume. Now we have combined all the tools, and each of them is indicating a reversal. Hence, we should take a position in the opposite direction. This is precisely the kind of setup that you need to be looking for every time.
In order to find the exact entry, we need to magnify the chart. For this, you need to go on a lower time frame to analyze and set your stop-loss or target based on that time frame. This is mandatory for getting precise entries. The above figure is the lower time frame chart of the explained example.
Note: Images 1, 2 & 3 belong to the daily timeframe, whereas Image 4 belongs to the 4H timeframe.
Step 3 – Enter the trade with a stop-loss and take-profit
The last step is to enter the market with a compulsory stop-loss and take profit to ensure risk management is in place. In this strategy, a stop-loss order can be placed above the price where the RSI enters the overbought/oversold zone. Avoid putting small stop-loss as you can prematurely get stopped out from the trade.
Profit can be booked when the volume of your trend starts to decrease. Now, the stop-loss and target would be placed, as shown in the above chart. This trade would result in a risk-to-reward ratio of a minimum of 1:5. Traders can also use a moving average or any other indicator to set a profit-taking price level. Limit orders are almost used by all traders to avoid any slippage or other issues, particularly in less liquid assets.
Fading strategies can be considered as risky as you are going against the trend. It is always a good idea to take a trade if the risk to reward ratio is favorable. These strategies are commonly used by short to medium term traders to capitalize on short term reversals. Even though it seems risky, it can be extremely profitable if appropriately used. This is because the market has reached a saturation state, and there has to be some balancing force. This is why fading strategies are also known as contrarian strategies. Because they work on the assumption that prices deviating far from the trend, tend to reverse and revert back. That’s about Art Of Fading. If you have any queries, let us know in the comments below. Cheers.