Many newbies ponder over fake breakouts. A breakout strategy is one of the first strategies you discover or feel compelled to trade when you first start trading.
Whether there’s a breakout from a range or another chart pattern, such as a triangle or just a tiny price consolidation, the aim of a breakout strategy is to catch a big move that follows an easy-to-spot pattern.
But, sometimes, you don’t get what you wish, and there appears a fake breakout.
So, what is a fake breakout, and how can you avoid it, and is there a way to trade it?
In this guide, we are going to answer these questions. So, make sure to stick till the end.
What are fake breakouts?
False-breakouts are just what they sound like: a breakout that did not extend past a certain level, resulting in a false breakout.
Following a breakout, a stock, forex, or futures contract appears to shift in one direction, traders enter, and the market rapidly reverses course, stopping them out or putting them in a losing position.
Fake breakout patterns are one of the most critical market action trading patterns to learn since a false break is either a very strong indicator that price is about to change direction or that a trend is about to resume.
A false break of a level can be thought of as a market’ deception,’ since it appears the price will break out but then easily reverses, manipulating all those who took the ‘bait’ of the breakout. It is common for amateurs to reach what appears to be a ‘obvious’ breakout, only for professionals to drive the market back the other direction.
As a market action trader, you want to learn how to exploit false breakouts rather than becoming a victim of them. A breakout trader takes a long position when the stock price breaks above resistance or a short position when the stock price breaks below support.
When a stock trades over the price barrier, volatility rises, and prices typically trend in the breakout direction. Breakouts are a crucial trading tactic because they serve as the starting point for potential volatility spikes, significant price fluctuations, and, in many cases, major price movements.
Breakouts can occur in any market setting. The most volatile market fluctuations are typically the product of channel breakouts and price trend breakouts such as triangles, flags, or head and shoulders patterns.
Volatility usually expands after prices shift outside of the identified ranges as it contracts over these time frames.
It is worth noting that false breakouts occur on all time frames regularly. Not every false breakout is profitable to trade. False breakouts are better traded in the trend’s direction. For example, if the trend is upward, a triangle pattern will form. Price splits slightly below the triangle, only to rapidly re-enter. That’s a trade you want to go long on because the trend indicates the price will rise.
How to avoid fake breakouts and trade them?
So, how can you avoid fake breakouts?
If false breakouts are continually frustrating you, the market is trying to tell you something. Instead of missing the breakout, why not trade the fake breakout? If you’re constantly losing money due to false breakouts, could you make some money trading alongside the traders who are? You may, and it’s a great technique, but it requires patience, concentration, and rapid reflexes.
Here are three tips you need to understand in order to escape from these breakouts and trade them:
1. Understand volume and patterns
No trader can predict whether the breakout will be a false break and fail. The market, as always, decides and dictates, and we traders must listen and obey – not the other way around.
Many traders make the mistake of observing and forecasting the markets and then blaming the market for failing to execute their strategy. Trading does not work like this.
You must locate trading volume, which serves as a guide for price. Also, keep in mind that breakout trade setups happen after chart trends emerge. It is critical to learn and identify all, or at least the most common, chart patterns.
For instance, look at the chart of AARTI DRUGS below. There’s a major breakout after the trading volume increased, and the price action formed a pennant pattern.
2. Finding key support and resistance zones
When trading breakouts, keep the underlying asset’s support and resistance levels in mind. The more times an asset price has touched these levels, the more accurate and significant these levels become. At the same time, the longer these levels of support and resistance remain in place, the better the outcome when the stock price eventually breaks out.
Various market trends will appear on the price chart as rates consolidate. When searching for stocks to trade, formations such as channels, triangles, and flags can be useful.
Aside from patterns, stability and the length of time a stock price has stayed within its support or resistance ranges are essential considerations to evaluate when looking for a good trading option.
As you can see on the 2H Nifty Bank chart, the price touched support and resistance areas, thereby indicating a downtrend with a potential breakout.
3. Waiting for a pullback
By zooming in on a single time frame and waiting for a pullback, you can trade breakouts. For example, if a pattern is apparent on a four-hour chart, you can zoom into a one-hour chart and search for a smaller pattern to appear on that time frame.
And when price forms a trend after firmly breaking out, it indicates that the breakout was not a false breakout. It demonstrates that price is constructing a new correction following momentum. This is a continuation signal.
The correction on the lower time frame has to be brief. Anything from 13 to 24 candles is acceptable. Depending on the overall market structure, a range of 24 to 36 may be appropriate.
If prices do not form a trend after the breakout, it is most likely reversing and heading quickly in the opposite direction. In that case, either price is forming a false breakout, or the price has reached a significant support and resistance level and is strongly bouncing. In any case, it’s best to avoid taking any position.
Here you can see ITC is forming a triangle pattern; there is a possibility of the price moving upwards. The correction didn’t last too long, so we can expect price action moving towards an uptrend.
How to enter trades?
The above-mentioned examples give an overall picture of trading breakouts. But what is the best possible entry point?
You will enter a bullish position once prices are expected to close above a resistance level. You will take a bearish position if prices are expected to close below a support level.
Wait for confirmation to tell the difference between a breakout and a fakeout.
There is no guarantee that prices will continue to rise if you move too quickly or without confirmation.
Many traders search for above-average volume as evidence, or they wait until the end of a trading session to see whether shares can hold the levels they’ve broken out of.
How to exit trades?
The best exit strategy is to average recent market fluctuations to determine a relative price target. This will be a fair profit goal if an asset has made an average price swing of four points over the last few swings.
It is important to understand when a trade has failed. Breakout trading provides this perspective in a reasonably straightforward manner. Following a breakout, old resistance levels should serve as new support, and old support levels should serve as new resistance. This is an essential aspect because it provides a reliable way to decide when a trade has failed and a simple way to set the stop-loss order.
After you’ve taken a position, use the previous support or resistance level as a boundary to close out a losing trade.
When a trade fails, it is important to exit the trade as soon as possible. Never allow a loss of too much breathing space. Losses will quickly mount if you are not cautious.
Points to remember when trading false breakouts
1) False breakouts occur in trending markets, range-bound markets, and markets moving against the trend. Keep an eye out for them in all market environments because they often provide clear hints as to potential market direction.
2) Trading against a trend is difficult, but one of the best ways to trade against a trend is to wait for a strong false breakout signal from the main support or resistance level.
3) False breakouts provide us with a window into the fight between amateur and skilled traders, allowing us to trade with the professionals. Learn to recognize and trade false breakout trends and trading can take on new meaning for you.
False breakouts encourage volatility. Since assets are hurrying after a breakout, the volatility encountered is likely to trigger emotion. Using the steps described in the article will assist you in developing a trading strategy that, when implemented correctly, can provide excellent returns while posing a manageable risk.
To learn the exact strategies and methods we use to trade in our daily trading, do check out the Mentorship section.