Using Rejection Candles to Detect Breakouts and Fakeouts

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Video Transcription:

Hello Traders! Welcome to the price action course and the second module, ‘Keep it Simple Stupid: the KISS approach.’ In this video, I’m going to teach you all about rejection candles, and how we are going to use these rejection candles to understand where the breakouts and fake-outs happen, so you are able to trade the right side of the move.

Now let’s start by talking about rejection candles. First of all, we need to follow this rule: we always wait for the candle to close. When we are waiting for a price to hit a supply or a demand level and when price hits this level, we always wait for the candle to close, and this is very important, and this might sound very basic. This is what’s going to tell you whether you are in a breakout or a fake-out. It’s as simple as that. The reason is that if you are looking at a demand level for example on the four-hour chart and the candle breaks with it and you decide to go short to trade a breakout, but the candle fails to close below it, printing a long down wick, you will be cut on the wrong side of the trade.

Rejection Candles

Now let’s look at an example so you can better understand this. Let’s say that you are looking at this chart right here. Price hit this resistance level and then came back all the way to make this low. This is a strong resistance level because of the strong rejections that we saw on price. Now, price continues to move up and what we are waiting for — because there is no trade right here — what we are waiting for is price to hit this level to see if we are going to be trading a breakout or not. And then, we see this candle print. When this candle prints, we decide to go long because we are making higher highs. And we are breaking with these highs. But this candle has not closed yet. Basically, what I want to tell you is that is that if this candle has not closed yet, what can happen is this. This candle can close all the way down here. And if you went long at this level right here, when this candle closes, you are already in a very bad shape because you are already in a losing position. And because of the length of the upper wick, we can know that this was in fact a fake-out. Why? Because price moved all the way up here, attempted to close above this high and above this resistance level, but bears came and pushed price all the way down here, making it reject this level and go and test these lows.

Using Rejection Candles

This is the first rule. We always wait for the candle to close. The rejection candle is going to tell us whether we are in a breakout or if that candle was just a fake-out of this resistance level for example. Now what we’re going to do is we’re going to go right into the charts and we’re going to look at some past price action or historic price action and we are going to determine whether we were in breakout situations or if we were in fake-out situations.

Okay guys, so this is the Aussie-U.S. dollar four-hour chart. And as you can see right here, we actually have a very good example of price trying to break above a very strong resistance level. Now, the first thing we’re going to do is we are going to determine where the previous high was. And the previous high was right here. So the first level the price needs to break is this high or this resistance level right here. And what we’re going to do is we are going to draw a horizontal line. The horizontal line is just going to give us a visual aid on the level that we are watching right now. Then we go back and we can see that the same level was tested as support before it broke below and then it was retested as resistance.

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So, basically what we’re looking at is at this pivotal level for a breakout trade or a fake-out trade. Now, what we’re going to do right now is we are going to draw the area because you need to remember that support and resistance are not just lines that you draw on your chart, but they are areas that you need to draw. Basically what we’re going to do is we are going to draw this low right here with this high right here. This is the entire area that price needs to break before we can assess if we are in a breakout or a fake-out.

Now, I need you to follow me on this one and I need you to see the actual area that I’m drawing. I’m using these lows because these tests at the level that we draw are very strong and then we broke below. And I’m going to be using these highs right here, which are the highs that price previously tested before it broke below. But we are going to use the wicks or the move. Now, this is the actual area the price needs to break with in order for us to be able to trade it. Now, if we were just using… let’s imagine that we were just using the horizontal lines that we drew on these highs. After this candle closed above it, we could have assessed that we were in an actual breakout and we could have gotten long right here with our stops below these lows, which means that we would have caught the end of the up move and the start of the fake-out. As you can see, we have closed below these highs and then another bull candle, which is a very strong bull candle. You need to understand how to read candles too. It is a very strong bull candle because it doesn’t have an upper wick and this means that price closed at the high of the period, meaning that the bulls pushed price all the way up here and it closed at the highs.

This could mean that we have a continuation of the move. But we haven’t broken with this pivotal zone that we drew as our main resistance area or supply zone. Now you can see that after this candle price moved a little bit to the up side and then crashed immediately to the down side, and this candle doesn’t have a down wick, which means that it took just one candle to erase three and a half candles of gain, which means that we have a very strong bearish engulfing candle and thus a very strong bearish move to the down side. And of course we just tried to break with the zone and then faked out. But what you need to understand too is that price is trapped inside a very narrow range and I’m just going to draw a small rectangle from these lows to these lows right here. And as you can see price came back to this area, retested the same area where we are finding a lot of bullish pressure. This bullish pressure, I think, is just protecting the 0800 level and then we moved all the way up here.

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Now, this is the candle that I need you guys to see. You can see that we are in a very choppy range right here. And the choppiness of the this range can be read through the wicks of these candles. We don’t have a very harmonious move to the upside or to the downside. We have what seems to be choppy ranges in-between and the wicks of the moves means that there is a very strong battle between the bulls and the bears. Now this candle moves above these highs or these supply zones that we draw right here. Let me zoom this in a little bit. If we had bought the Aussie-US dollar when this candle was at this high, we would have been caught in another fake-out because you can see that the bull pressure was not enough to close above this supply level. But the bears actually pushed price down and continued to push it down right here. And now we are trapped inside what seems to be a triangle formation.

This is basically what you need to understand. One, you need to draw the pivotal level, which you can draw using the previous highs or the previous lows. And then you go back in price action and you draw the actual supply and demand zone. This zone can be justified just by looking at this trump down move. Then price tested these areas here once, faked down twice, then retested this area again, which means that this low or this wick is an actual demand area and then retested the pivotal level and you can see was trapped inside this supply zone before it broke down and then we found some bulls protecting the 0800 level. But this is basically what you need to do. You need to wait for the candle to close above or below the level to be able trade a breakout. And if you see price rejection candle, you can trade the other side of the move, meaning that you will be trading a fake-out.

The most conservative way to trade a breakout is this. Now, let’s assume that we are looking at these zones right here. The first thing that we’re going to do is we’re going to draw a horizontal line at this low, because you can see that price tested this low and then printed a very small-bodied and long down-wick candle and then moved up. This means that we have encountered some buyers here. We go back in price action and you can see that the actual area is this one right here. This is the actual demand zone. You can see that price retested the same pivotal level and then broke with it. Now, the aggressive way to trade a breakout would be to go short right here when the candle closes below this support zone. And our stops would have to go all the way above the previous highs, which would mean that we would have to use a 110 pips stop-loss.

This is fine and it all depends on the risk… well, the position size depends on the risk of your fewer count. It doesn’t depend on the actual stop-loss. So this is the aggressive way to trade a breakout: you go short, you put your stops above the previous high, and you can see that the stops are not taken out and price moves all the way down here for a very nice… if we are calculating from these lows to the next pivotal zone, for a very nice 328 pips.

Now, the other way to trade breakouts is, if this breakout is not induced by some out of the ordinary news or out of the ordinary volatility, you wait for the breakout and then you wait for the retest of the area — in this case — as resistance. You can see that we have a small-bodied and long down wick candle that rejected this area of support. And then we have the small-bodied and long up wick of the candle rejecting the same area as resistance. This means that price retested the same previously retested area of support as resistance. When this happens, you can go short at the close of this candle and you can put your stops above the previous highs of course, because if price breaks with the previous highs, your trade idea is invalid. And if you go from this entry to this new pivotal area, it will mean that you will have made 364 pips on apparently a 70 pip stop loss. So this is a very good risk-to-reward ratio and basically a 4.9:1 risk-to-reward ratio on a breakout trade. So, this is why it’s so important to understand rejection candles when you are trading breakouts or fake-outs.

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