Warning: Breakouts Fail. Here’s What To Watch For

Posted in: Advanced Trading Strategies, Trading Article

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Simple works in trading and by that I mean pullbacks and breakouts from consolidations because that is how the market operates.

Markets move from a trending environment to a consolidated environment repeatedly which makes taking advantage of simple price patterns a smart play.

In an earlier post about pattern failures, I talked about trading pullbacks where I covered:

  • What sets up a good pullback for a potential continuation trade
  • What a failed pullback pattern looks like
  • The characteristics of a good pullback in price

Price will eventually begin to form a consolidation pattern, from short term to long term consolidations, and then resume its trend.

 

You Don’t Have To Wait For The Breakout?

Traders can find it tough to trade inside of consolidations for a variety of reasons including price appearing to move in a more sporadic fashion.  It’s often times difficult to see what is gaining control while price consolidates.

I rarely trade the actual breakout for a few reasons:

  • Breakouts that have strong momentum out of the breakout, can quickly mean revert depending on the strength of the breakout
  • Trade can be in profit before the breakout and reap quicker profits when momentum occurs on the breakout
  • Risk is more defined

Not the scope of this post however I want to clarify what I am looking at to position before a breakout if possible.

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Once a range begins to form on a higher time frame, head to a lower time frame chart to watch for price formations that could help you position in consolidation before the breakout.

The question you should have right now is: “How do I know a range is forming?”

As a rule of thumb, look for a few days where price is travelling sideways on your higher time frame chart.  I generally look for three days and then drill down to see what price pattern may be forming.

    1. The first entry could be a test of former resistance as price pushed with momentum off the support level of the range and failed to break higher
    2.  The second entry is similar to the first but we are seeing another consolidation near the support level of the range

If you choose to place your  protective stop over the resistance zone of the range, you can see you will be able to have a smaller stop in relation to your trade entry.  For many traders, especially Forex traders, a smaller stop is something they look for to increase position size.

There are other stop areas including over the zone where you placed your trading entry.

 

What Type Of Action Points To Breakout Failure?

In a perfect world, every breakout will be the start of a year long trend and you are fortunate enough to catch the start.

In reality, a breakout will fail and the losses can add up if you trade every breakout without some type of edge.

Let’s drill into this chart and see if the breakouts were showing any signs of failure.

  1. While this breakout does head to the upside for a few days, it does not last.  As price hits resistance, upper shadows register which signal price rejection.  Although we have a slight breakout of highs, price also consolidates after the breakout.  While a consolidation does not always spell doom, the location is suspect as it is sitting on top of resistance and potentially support
  2. Price ranges for over a week and actually retests the same price location as #1 several times.  We have a strong momentum candlestick break resistance but there is no follow through.  While the first red candlestick may not have made you exit, you’d want to be out when price makes no move upside the following day.
  3. I’m including this as part of #1 because it can be argued this move is a result of that breakout and upside push.  A pullback after a breakout is not cause for alarm in general, this type of pullback is not a welcome sight.  A trader may have held on for the first two candlesticks but the momentum behind the third would have even an aggressive trader hit the exit

If we can consider that breakout at #1 a success even after the consolidation (price does move with momentum), we can treat the pullback just as we would any other pullback trade.

 

Chart Patterns Succeed And Fail

A chart pattern is just a pattern of price and we are trading the imbalance that creates the pattern.

We can trade the actual breakout which at the time of price breaching the level, there is an obvious imbalance.  We can position before the breakout if we see price action/price patterns that indicate who holds the balance of power prior to the break

While it is wonderful to be on board a breakout that busts with momentum, you must know what the breakout would look like if it were short lived.

I would suggest that knowing what a pattern failure looks like is more important than what a successful one does.  Take the time to look over every chart pattern you are trading and ask yourself “if it fails, what would it look like?”

A failure may not be the go-ahead for a trade in the direction of the failure, it can certainly keep you out of a bad trade or at the very least, allow you to mitigate risk with any open position.

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CoachShane

Trader at Netpicks
Shane his trading journey in 2005, became a Netpicks customer in 2008 needing structure in his trading approach. His focus is on the technical side of trading filtering in a macro overview and credits a handful of traders that have heavily influenced his relaxed approach to trading. Shane started day trading Forex but has since transitioned to a swing/position focus in most markets including commodities and futures. This has allowed less time in front of the computer without an adverse affect on returns.

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