In the world of trading, trend following is a popular strategy that involves buying and holding an asset whose price is rising while short-selling an asset whose price is falling. This strategy is often emphasized with phrases like “the trend is your friend” and “don’t catch a falling knife”. However, there is an alternative approach that claims the opposite, known as fading. Fading is a contrarian way of trading that involves going against the trend, and it can be a risky strategy. In this article, we will delve into the workings of fading trading and explore how it can be used to make better trading decisions.
What is the Fading Trading?
Fading trading is a contrarian strategy that involves buying an asset whose price is falling and shorting one whose price is rising. This approach is based on the assumption that a price has moved to an overbought or oversold level and that existing buyers of an asset will start taking a profit after it rises sharply in a short period. To do this, traders assume that a price has moved to an overbought or oversold level, which they can identify using technical tools such as the Stochastic Oscillator or Relative Strength Index (RSI). They also assume that buyers of an asset will start taking profits after a sharp rise, leading to a period of distribution. However, the strategy also assumes that existing holders of an asset are at risk, and they may start exiting their trades, making the approach risky.
Fading Trading Strategy
Fading trading is a contrarian strategy where traders attempt to buy an asset whose price is falling and a short one whose price is rising. For this strategy to work, there needs to be an existing trend. After identifying an existing trend, a trader uses strategies to take the opposite route. One of the most common strategies is fading the news.
This involves buying an asset that has fallen sharply after a major news announcement or shorting it if it has risen sharply. Another popular strategy is to use oscillators like the RSI, MFI, or Stochastic Oscillator to identify overbought and oversold levels.
Fading traders also use chart patterns to identify reversals. For example, if a rallying trade forms a double-top pattern, there is a high possibility that it will start to retreat in the near term. Finally, traders can also fade the gap. This is a trading strategy where you attempt to go in the opposite direction of the gap. Fading trading is a risky strategy since a trend can go on for a long time, but it can be profitable if executed correctly.
Buy Signal
- Fading the news:
- Traders may open a long position when a stock or currency pair jumps sharply after the release of important news and then stabilizes after a short period.
- Traders may take profits when the price stabilizes or starts to retreat.
- Traders may set stop loss at a level that makes sense based on the market volatility and their risk tolerance.
- Using oscillators in a fading strategy:
- Traders may open a long position when an asset is extremely oversold based on an oscillator like the RSI or stochastic oscillator.
- Traders may take profit when the price starts to retreat from the overbought level.
- Traders may set stop loss at a level that makes sense based on the market volatility and their risk tolerance.
- Fading the gap:
- Traders may open a long position when there is an up gap and vice versa.
- Traders may take profit when the price starts to rebalance after the overreaction.
- Traders may set stop loss at a level that makes sense based on the market volatility and their risk tolerance.
Sell Signal
- Fading the news:
- Traders may open a short position when a stock or currency pair jumps sharply after the release of important news and then stabilizes after a short period.
- Traders may open a position when these conditions are met.
- Traders may take profit when the price stabilizes or start to retreat.
- Traders may set stop loss at a level that makes sense based on the market volatility and their risk tolerance.
- Using oscillators in fading strategy:
- Traders may open a short position when an asset is extremely overbought based on an oscillator like the RSI or MFI.
- Traders may open a position when these conditions are met.
- Traders may take profit when the price starts to retreat from the overbought level.
- Traders may set stop loss at a level that makes sense based on the market volatility and their risk tolerance.
- Fading the gap:
- Traders may open a short position when there is a down gap and vice versa.
- Traders may open a position when these conditions are met.
- Traders may take profit when the price starts to rebalance after the overreaction.
- Traders may set stop loss at a level that makes sense based on the market volatility and their risk tolerance.
Fading Trading Pros & Cons
Pros
- This strategy can be used in both bullish and bearish markets.
- Using oscillators and other technical indicators can help identify overbought and oversold levels, making it easier to enter trades at the right time.
Cons
- Fading Trading can be risky, as traders are going against the prevailing trend.
- Trends can continue for longer than expected, resulting in losses for fading traders.
- It can be challenging to accurately identify the end of a trend, leading to false signals and missed opportunities.
Conclusion
In conclusion, fading trading can be a profitable strategy for experienced traders who are willing to take risks and have a good understanding of the market. However, it is important to be aware of the potential drawbacks, such as high volatility and the risk of being caught in a trend reversal. Like any trading strategy, it is important to carefully consider the pros and cons before making any trades.
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