Looking for the Best Price Entries? Trade Failed Breakouts

[RichardCox 10]

When forex traders are getting started in learning about technical analysis techniques, one of the first terms that we come across is the “breakout,” which is a pattern formation that lets traders know that significant momentum is present in the market. True breakouts indicate major turning points in market sentiment, as highly significant and closely watched support and resistance levels are overcome and invalidated. In most cases, these important levels of supply and demand (support and resistance) hold, and help to guide price activity. So when these levels break, it implies market dynamics are changing and that prices are ready to travel forecfully in the direction of the break.

 

No Guarantees in Trading

 

In some cases, however, these breakouts are “false,” or not truly indicative of changes in the market. False breakouts can happen for a variety of reasons: Erratic order flows can cause choppy trading conditions, there are not enough traders on the side of the break to carry prices further, or we simply have the wrong levels of support or resistance that are truly present in the market. When these false breaks occur, markets are left in a very precarious position, and many traders that bought or sold into the direction of the break are forced to exit their positions. This, of course, sends prices even more forcefully in the direction opposite the break, and leads to increased volatility in the currency pair you are watching.

 

When breakouts are successful, it is because there are usually large amounts of stop losses placed just above and below critical levels of support and resistance. So, when these levels are broken, the orders are tripped and this adds to the momentum seen in prices. But it should always be remembered that there are no guarantees in trading. If traders knew that a large number of stops are at a certain price levels, all we would need to do is place our orders in those areas and ride the wave to constant profits. This, of course, is unrealistic, and for these reasons, breakout trading could not possibly work 100% of the time. Here, we will look at how to play the situations that do not work out as the market had originally planned, the false break.

 

Examples of Breakouts and False Breakouts

To understand how we visualize false breaks, we must first understand how to visualize true breakouts, where violations of critical support or resistance levels leads to increased momentum and extended follow-through. The first charted example shows the structure of a bullish breakout, where support and resistance levels are clearly defined (multiple touches), before prices finally make a clear break to the topside. The second charted example shows a live chart in the other direction (a bearish break). An important element to note is that once prices make the bullish break, they fall back to the original resistance level, which now becomes support (and prices extend higher). For the bearish break, prices rise to test previous support (now acting as resistance) before making a significant drop.

 

Consider the bullish example. What would happen if this level did not act as support? This would mean that a false break is in the works, and traders that bought into the upside break of resistance would now be caught long at expensive prices levels (making their positions vulnerable to substantial losses if tight stop losses are not used). In the third charted example, we can see an early false breakout. So let’s next look at the elements of a false breakout, so that trading opportunities can be identified when they arise.

 

● Price breakout occurs

● Insufficient momentum causes prices to move back through the prior support/resistance level

● Short-term breakout traders are stopped out, and prices reverse violently (such as in the proverbial “short squeeze”)

● Reversal slows once stop losses are covered

 

Reacting to Failed Breakouts

 

Once a failed breakout is identified, you will find yourself in one of two positions: You either traded in the direction of the break and you are looking for a place to exit the trade, or you have no exposure to the asset and you are looking for an opportunity to enter. Traders already in a position will likely need to exit quickly, as reversal volatility can quickly lead to big losses. This is why tight stop losses are essential when breakout trades are opened. Breakout trading becomes complicated, however, when slippage is involved and this is a clear possibility given that these market scenarios are accompanied by extreme increases in volatility.

 

So, how can we structure trades based on false breakouts? The charted example of a failed break comes after an upside breakout. Once prices fall back through the previous resistance level, we have our signal that the bullish breakout was false, and that the bias is now to the downside. Based on this, short positions can be initiated. The main benefit of these types of trades is that we know we are getting in at the best possible price for bearish trades (the upper end of the range, after all upside momentum has failed).

 

For these reasons, trading failed price breaks enables traders to get into positions at the best possible price levels (expensive valuations for short positions, cheap valuations for long positions). This benefit comes in direct contrast to trading valid breakouts, which require traders to enter into long positions at elevated valuations (after resistance has already broken), and to enter into short positions at very cheap valuations (after support levels have already broken).

 

Structuring Trades

 

Let’s assume that we are going to enter a trade based on the failed bullish breakout in the charted example. The short trade entry can be initiated as prices move back through the previous resistance line (as momentum is now in the bearish direction). Stop losses should be placed above the previous spike high. The reasoning here is that any price activity above the breakout high will suggest that an uptrend is in the early stages (with a series of higher highs visible). So, if prices were to overcome the spike high, the original breakout would be a true one and not a false one.

 

Since breakout events typically happen in range trading scenarios, it would make sense to place your profit target inside of the support level of that range. More important, however, is to be aggressive with your stop loss movement. Since volatility is heightened in both breakout and false breakout environments, it is important to reduce risk whenever the option is available. Specifically, this means moving your stop losses to break-even (and even taking partial profits) as soon as your trade is in the black.

 

Once false breakouts are identified and trades are placed, momentum should be on your side and you should see unrealized profits relatively quickly. If this does not occur, it is often a good idea to simply close the position and look for opportunities elsewhere. Being aggressive with your stop losses and profit targets will help you to avoid the volatility risk that is often associated with these types of trading strategies.

 

Conclusion: False Breakout Offer Excellent Price Entry Levels

 

It is true that false breakout scenarios usually involve increased volatility and very erratic price activity. These situations are best managed by short-term traders that are able to closely monitor positions once opened. If this is not your approach, it is unwise to trade these failed patterns. But, at the same time, significant advantages can be found. Specifically, failed breaks allow you to capitalize on the stop loss momentum that is generated by stopped breakout positions. In addition to this, failed breaks enable traders to get in to positions at the absolute best levels, with short entries opened near resistance levels and long entries opened near support.