Head-Fake Trade

A head-fake trade is a trade where a stock or market appears to be making a move in one direction, but then reverses course and goes the opposite way. The head-fake trade gets its name from a tactic commonly used by a basketball or football player to throw the opposition off, by leading with his head to pretend that he is moving in one direction but then going in the opposite direction. The head-fake trade occurs most frequently at key breakout points, such as major support or resistance levels, or moving averages like the 50-day or 200-day MA.

Consider a situation where a major market index has been hitting new highs amid deteriorating economic fundamentals. Traders who are looking to short the index will be closely monitoring its technical levels to assess whether the advance is beginning to break down. Suppose the index advance stalls and it begins to drift lower, trading below a key short-term moving average. The bears might rush in at this point based on their trading view that the index decline has begun, but if the index subsequently reverses course and heads higher, this would be a classic head-fake trade.

Contrarian traders are more likely to be taken in by a head-fake trade than trend-followers, since a contrarian trading philosophy is based on a willingness to go against the crowd. As traders and investors who fall for the head-fake trade can incur significant losses, an adherence to strict stop-loss limits is necessary in such cases.

What makes breakout trading difficult is that an initial breakout is typically followed by some level of pullback. As price retraces back to the original breakout level or somewhat further, the trader is left to determine whether the breakout pullback is the beginning of a head fake – a false breakout – or whether the pullback is temporary and the market will soon continue in the direction of the breakout. In the latter case, the pullback can be an opportunity to get on a breakout move after it has first developed.

There was a significant number of head-fakes during the record bull market that commenced in March 2009. Perhaps the best-known example is the "Flash Crash" of May 6, 2010, in which the Dow Jones Industrial Average (DJIA) plunged almost 1,000 points in a matter of minutes in intra-day trading before erasing most of that loss by the close. Traders who may have put on large-scale long-term bearish bets on U.S. equity indices based on the view that the "Flash Crash" portended a new bear market, had the mortification of seeing these indices go on to record highs in subsequent years.