When I was a newbie trader, the first thing I learned was price action trading.
I would look at a naked price chart and make my trading decisions out of it.
I could see the market break out, a strong bullish momentum and large candles.
To avoid missing out on the move, I would buy.
So what would happen next?
The market would reverse, I cut my trade and suffer a loss.
I did this for a number of times!
I lost track of the number of times I did this!
Every time the market showed a strong rally, a strong momentum and larger candles, I would buy that type of breakout.
And I kept losing money consistently.
After staying in the trenches for a number of years, I realized that chasing after such breakouts is a way of losing money.
So, the question is, how can you avoid false breakouts?
This article will teach you this!
You will learn the following…
A false breakout is just as its name suggests: It’s a breakout that fails to continue beyond a particular level, which results to a “false” breakout of that level.
The price breaks an obvious level, but it suddenly changes direction!
When an initial breakout occurs, many traders enter the market in the direction of the breakout.
If a price reversal occurs, such traders will be trapped, and a cascade of stop loss orders will be triggered.
But, what causes the breakout to reverse?
Normally, when the price breaks out an obvious level, new traders will see it and enter the market.
This has an impact on the price, as it piles pressure on it.
Such a reaction results into a new trend that is opposite to the initial breakout, which is the false breakout.
Let’s use a chart to make it easier just for you…
Above we have an inverted head and shoulders chart pattern.
The red line is the neckline for the pattern, and is considered the signal.
The red circle shows an upside breakout through the pattern’s neckline. This confirms the inverted head and shoulders pattern.
It also creates a very strong bullish potential on the chart.
However, there is a sudden rejection of this bullish breakout by the price action.
The price reverses quickly, creating a bearish move. This means that the breakout in the red circle was false.
A false breakout flushes out traders who might entered a position because of emotion, rather than forward thinking and logic.
In the above chart, all traders who had entered the market after the occurrence of the breakout were caught on the wrong side of the market.
That is how I used to trade, and many are the times I found myself caught up in such a situation !
In short, I learned the hard way, why wait to learn the hard way?
You don’t have to…
Newbie traders tend to enter the market when they feel it’s safe to do so. This means they enter the market when it seems extended in one direction.
Professional traders watch out for these mistakes made by newbies, which helps them enjoy a good entry with a tight stop loss and a great risk reward ratio.
Again, you must know how to identify and trade false breakouts.
Let’s begin with the identification…
This forms the trickiest part in trading false breakouts.
If you can’t identify a false breakout correctly, you can’t trade it profitably!
For example, at times, you will mistake a price action for a false break, only for the price to return back to the breakout point, confirming the initial breakout. The price then continues in the direction of the initial breakout.
The best way to identify a false breakout is by observing the trading volume.
Real breakouts are normally accompanied by strong trading volume readings in the same direction as the breakout.
If this volume is not present, there are high chances that the breakout won’t materialize.
So, if you observe a low or decreasing trading volume during the time of the breakout, it could be a breakout trap.
The vice versa is true. If the trading is high or increasing, then a real breakout could be occurring on the chart.
Above we have a breakout occurring in a bullish trend. The volume indicator has been added to the bottom of the chart.
From the volume indicator, the trading volume is increasing at the time of the breakout.
Even after the breakout, the price kept going the same direction as the break.
This means that the breakout has been confirmed by the volume, creating an attractive opportunity for traders to trade trend line break to the downside.
Above, we have a breakout that occurs at a time when the trading volume is decreasing. After the occurrence of the breakout, there is a sharp reversal in the price.
This makes the pattern a fakeout!
Yes, the trading volume is a good indicator for confirming whether a breakout is real or fake.
However, it is not foolproof!
It will always be good for you to move down a timeframe to grasp a granular view of the price action and see whether you can get an additional supporting evidence of a fakeout or a breakout!
This means that in addition to monitoring the trading volume, you must also monitor the price action on the lower timeframe.
In some cases, you will realize that the prices creates a sharp pullback on the lower timeframe that is not visible on your trading timeframe.
Frankly speaking, there is no way for you to completely avoid false breakouts!
There are times when no matter how good the setups seems to be, you will still be caught up on a false breakout.
It takes a bit of “gut feeling” and much discipline to when a false breakout will occur.
Also, you cannot really know “for sure” until it forms.
However, it’s possible to minimize the chances of being caught up in a false breakout.
I will give you 2 tips!
The first tip is….
#1: Don’t chase parabolic moves
This type of move is created when the price moves up with little to no pullback then it moves up higher.
The above movement shows a big ballistic strong momentum.
You should never try to chase such a breakout!
The price will soon reverse!
And guess what, the price reversal will be sharp!
When you chase the market during a parabolic move, it means that there is no floor to support the high prices.
Markets with such moves should have swing lows to support the high prices…
What does it means?
It means that if the market reverses, it will find support or a floor. At the support, the price may be pushed higher by the buying pressure.
Such price moves are more sustainable since there are a series of higher floors to support the high prices.
So, what happens when the prices has gone parabolic?
In case a reversal occurs, it can be very swift towards the downside and back to the nearest support or floor where the buyers may come in.
So, don’t chase parabolic moves!
And the second tip is…
#2: Trade with a build-up
A build-up is said to have occurred when the market is in consolidation.
There are three ways to identify a build-up in your chart pattern:
It may be a series of higher lows into resistance, forming a figure somewhat like an ascending triangle.
It may be a lower high into support, forming a figure somewhat like a descending triangle.
And finally, it may be a tight consolidation at a market structure such as resistance or support.
Consider the chart pattern given below :
The above pattern is almost forming an ascending triangle, a kind of a build-up.
Notice that the market range is getting tighter and tighter.
The build-up is forming!
Also, the size of the candles in the market are getting smaller and smaller. This should continue until a point where the candles don’t move.
When trading breakouts, make sure that you see this phenomenon, the candle size and their range should get tighter.
It’s called a build-up!
In the above case, it is in the form of lower highs trying to reach the resistance, forming a descending triangle.
From the price action perspective, the buyers are getting weak.
First, these buyers are very strong with no problem, pushing the price from low to high.
Then, something happens…
Every time the buyers try to push the price higher, the distance they’ve moved gets smaller and smaller.
What does it mean? They’re getting weak!
Sellers on the other had are trying to push the price lower and lower. That’s how a descending triangle is formed.
Consider the following chart showing another build-up that is formed…
Notice that we have a tight and nice consolidation, which is an indication of strength.
So, what is happening?
The price has reached the resistance, and there is a potential selling pressure for the price to be pushed lower.
The market is holding up at the resistance, which means that:
There is no selling pressure at the moment.
There are strong buyers who are willing to buy at higher prices.
However, in all cases, this is an indication of strength!
The market did not break out!
It reverses, then breaks out even higher.
So, what should you do after a build-up is formed?
You can reference your nearest market structure to set your stop loss.
You can place your stop loss just 1 ATR below.
The market structure will act like a barrier, denying the reversal an easy passage to go through.
After the price structure, the bias came in again, pushing the price higher.
That is how powerful a build-up is.
It gives you a tight stop loss and market structure for holding up the reversal or a pullback in case it happens.
If you trade without a build-up and the market reverses, there will be no level to support the higher prices.
That’s the reason why markets reverse all the way down to the nearest market structure, that is, the area of support.
Therefore, a breakout comes after a build-up!
To succeed in forex, you must stay disciplined!
So, how can you stay disciplined when trading false breakouts?
Simply, you need to create rules that define your entry point, where to place your stop loss order, and the price target.
Now, let’s get into them…
You must time your entry when trading false breakouts.
When you spot a break out of an obvious level, with the volume being low or decreasing, you can enter the market once the price returns to test the level.
If the return happens with a higher momentum than the break, then there are high chances that the price is a false breakout.
If the key level breaks in a bullish direction and on a low volume, you can short the forex pair on the bearish pullback.
The key level can take many forms. It can be a horizontal resistance or support or level, a parallel price channel, a diagonal trend line, a pivot point, a candle pattern, a chart pattern, a Fibonacci level, etc.
Price seems to be volatile around fake breakouts.
This makes risk management an important aspect in when trading false breakouts. In some cases, a real breakout can be mistaken for a false breakout.
The trader will only realize this once the breakout tests the key level and continues in the direction of the original breakout, confirming a real breakout.
That’s why it’s important to place a stop loss order to protect your trade. It is the best approach for you to limit your risk when trading a false breakout.
So, what is the ideal place to place a stop loss order when trading a fakeout?
Place it on the opposite extreme of the initial breakout.
This is shown below clearly…
We had used this chart before, but I have now marked the correct place for the stop loss order.
In most cases, the stop loss order will lie relatively close to your entry point.
This is good for you. Why?
It will give you an attractive risk to reward ratio.
If the price makes a sharp reversal, you will be able to place the stop loss fairly tight.
And if the price breaks this level, it will be confirming that you’ve a real breakout.
There is no specific target in fake breakouts…
However, chart patterns are different since they mostly suggest a target at a distance that is equal to the pattern’s size.
If the fake breakout has happened within a chart pattern, just measure the size of the formation then apply it from the opposite side beginning from the fakeout price extreme.
If a fakeout occurs during a low trading volume, there are high chances of seeing a pickup in the volume during the pullback time and beyond.
What does this mean?
Hold your trade provided the volume is strong during the impulse move.
If the volume drops, the price may be getting exhausted, and it may be good for you to close the trade and collect the earned profit at the time.
Also, always keep an eye on the price action!
It is a useful approach to any trader looking for an exit point.
- A false breakout is said to have occurred when a breakthrough a key level is rejected.
- False breakouts happen in range-bound markets, trending markets and against the trend.
False breakouts give clues about an impending market direction, hence, they should be watched keenly.
False breakouts are characterized by a sharp reversal in price after it has peeked through an obvious level.
Since a false breakout makes a move contrary to the initial breakout, many traders are caught in the wrong side of the market.
Use the trading volume indicator to differentiate between real and false breakouts.
The best way to avoid false breakouts is by not chasing parabolic moves.
Parabolic moves are associated with a sharp reversal in the price.
The reason is that there is no floor to support the high prices.