Have you ever experienced the frustration of a breakout that quickly reverses, hitting your stop-loss and leaving you with a losing trade? It’s a common occurrence. A price breaks out of its trading range, you jump in, but then it snaps back, seemingly mocking your strategy. While frustrating, these “false breakouts” can actually be opportunities in disguise.
Before reacting to a breakout, it’s essential to determine whether it’s a precursor to a genuine, sustained move or just a temporary fakeout. Both scenarios offer unique trading possibilities.
Identifying False Breakouts: Key Indicators
Here’s how to assess a breakout’s validity:
- Align with the Larger Trend: Zoom out to a daily or weekly chart. Does the breakout align with the overall trend direction? A breakout that follows the prevailing trend is more likely to be real. If it goes against the larger trend, it’s a red flag for a potential false breakout.
- Corroborate with Fundamentals: Does the breakout coincide with significant news or economic data that supports the move? For example, if the EUR/USD pair breaks upwards following positive European economic news or negative US news, the breakout is more credible. If the news contradicts the breakout or there’s no supporting news, it’s likely a false signal.
- Analyze Liquidity and Volume: Breakouts backed by high trading volume and liquidity are more likely to be genuine. For instance, the European afternoon/US morning is a high-liquidity period, whereas the time between the US close and the Tokyo open is typically low-liquidity. Moves happening during low liquidity periods, like the “flash crash” of the pound, are more prone to failure and reversals.
Trading Scenarios: Real vs. False
- If it Looks Like a Real Breakout (But Faked Out Initially):If your assessment suggests a breakout’s validity based on trend, fundamentals, and liquidity, the initial false break might have been a short-term setback. This can present a second chance. Instead of waiting for a new breakout, consider entering while the price is back within the original trading range. This approach can offer an even better risk-reward ratio.If you anticipated the breakout, consider using a slightly wider stop-loss to accommodate the possibility of an initial false move.
- If it Looks Like a False Breakout:If the above indicators suggest the breakout is likely false, seize the opportunity to trade against the direction of the breakout. For example, if the price fakes a downside break, consider entering a long position, anticipating a return to the range. Conversely, a false upside break presents a shorting opportunity. You can capitalize by trading the price back into its previous trading range, effectively buying low and selling high (or selling high and buying low).
Final Thoughts
False breakouts can be frustrating, but they can also be profitable. By learning to identify them and adapting your strategy, you can turn these deceptive moves into potential trading opportunities. Do you trade false breakouts, or do you prefer to stay on the sidelines?
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