A breakout is a common price pattern and they are a frequent occurrence in any market. There occur at enough frequency that there are breakout traders who only look for that type of price action.
Think about it: Where does a trend start? On the breakout of consolidation so knowing what a false breakout looks like is vital.
While I’ve never seen the stats, the majority are false breakouts where price looks like it is set to run, but then does the opposite. If you are a breakout trader, you must know what a false breakout looks like so you are not hanging on to a trade that is about to rip against you.
Breakout trading is a popular method of trading because if you can get into a breakout that turns into a trend, you have effectively “found the top or bottom” of what could be a long term trend direction.
Potential breakouts are not hard to find either.
- Finding a trending market, look for pullbacks and then a break in the same direction of the high or low pivot
- Look for consolidation (trading range) and look for price to take out the high or low
- You can look for a trading indicator such as a moving average to be “holding price”
- Using a higher time frame like a daily chart can filter out some of the noise so you can see price extremes more clear
But false breakouts can cost a trader.
We know that many traders have no idea about risk management, put too big a position size on, and when the breakout fails, their trading account takes a hit and their equity curve can take a dive.
Even With False Breakouts, Should You Trade Breakouts?
Yes, breakouts fail but think about what can happen if you catch the “right” breakout. Think of the Forex market for example. Currency trading is highly influenced by interest rates, the health of economy, and even the words of an elected official.
This Forex chart shows a decline of over 2100 pips and the red box indicates where it all began – a successful breakout.
Breakout traders who know what to look for to signify a false breakout, entered into this move and caught a 14% move. Depending on how they manage their risk, this could have easily made up for any trading losses they took during the false breakouts that happen.
False breakouts are a normal part of trading but there are ways that you can avoid getting caught (or at least mitigate any loss) if you know the type of price action to look for. We all know what a successful breakout looks like – just look at the chart.
It’s knowing what to look for to show that the breakout you are trading is about to fail is more important.
What A Good Breakout Looks Like
If you are thinking of trading breakouts, the first thing you should know is what sets up the potential for a strong breakout?
For that, we just have to look for price action and the forming structure.
As price continues to hit up against resistance, you notice price action is making higher lows into resistance indicating accumulation. This tells you that buyers are willing to pay higher prices in this market even as price doesn’t make new highs. The chances for a successful breakout increases when players that can actually put in these higher pivot lows are looking in the same direction as the potential breakout.
Another great pattern is when you get a consolidation right below (or above for support) resistance. This is actually a great place to attempt a position before the breakout especially if you see a type of failure test of lows (in the case of looking for breakout longs).
If you are thinking of positioning inside this smaller price range, you may not get price “tipping” its hand with pokes below and recovering back inside the range. You may see even a smaller range inside this range. The point is, sometimes you just have to get the position on, set your stop, and let things play out as they will.
Once the breakout occurs, a pullback is not a bad thing if you are seeing a “lazy” pullback in price. If you are already long using a trading pattern we’ve talked about, seeing this type of action should not alarm you. In fact, pulling back below former resistance in this manner does not invalidate the breakout which is why the textbook version of your stop loss (just below former resistance) is wrong. It ignores the evolution of price.
If you are a breakout trader who waits for the breakout and trades the pullback, you are actually NOT trading the breakout. You are trading a pullback in price and while that may appear to be semantics, it’s not especially if you are using breakout trading rules for pullback trades. Each pattern is different and comes with their own sets of complications.
There are other variations of these patterns but for signs of a good breakout, you’d like to see accumulation of some sort, failure tests of lows (highs) and a lazy pullback.
While these don’t guarantee the breakout won’t eventually fail, it does set certain parameters on how you are trading this pattern. With that, you can set up rules surrounding stops and targets that will help keep you consistent.
Failed Breakouts – What Are The Signs?
The obvious sign the breakout is failing is there is no follow thru once price has broken the resistance or support zone. “Once” is subjective..follow thru can happen a few bars later.
Let me correct that…it’s the obvious sign to a perfect breakout failing. Having consolidation after the breakout is not a bad thing as long as we are not seeing hard moves against the breakout direction.
This shows price shooting up from the support zone right through the resistance level. We have no signs of accumulation and in fact we may have seen much of the potential energy of the breakout erased as price rockets from the bottom after it cleared out the previous accumulation that was occurring in that smaller trading range.
When I see this type of action, I am put on alert that trading the actual breakout is not possible, a breakout failure is pending, and I will have to look for the nature of the pullback if I am interested in a long position.
While I don’t have reams of stats showing this is a breakout failure waiting to happen, my experience (and the normal evolution of price) has shown that at least a pullback is coming. Often times you will also see many technical indicators (depending on the look-back period) start heading into overbought territory.
This appears similar to the last example and is especially relevant if the resistance level was actually put in place after a strong thrust up in price. If you think of what makes a good pullback as being a strong impulse leg, this resistance is formed as the pivot level of the strong impulse leg.
With price closing up and over resistance but then charging back down, this is not a good sign and points to a false breakout instead of a successful one. While this pattern may not lead to a complete change to a down trend, it does put the uptrend potential in jeopardy at this time.
Everything looks good for the breakout trade:
- Higher lows into resistance
- Consolidation under the level
- Strong breakout with 3 bars of a lazy pullback which if you are holding longs is not a bad sign
That’s where it ends.
A strong momentum move against this breakout is not a good sign. If you remember earlier we talked about the pullback after a breakout being an actual pullback trade, here we have a failed pullback because you do not want to see a strong move in the direction of the pullback (the corrective leg).
Can You Trade Failed Breakouts?
When a breakout fails, there can be the opportunity for a trade as long as you keep expectations in check. Thinking you are catching a major trend change and then attempting to hold one when price tells you difference is a mistake.
Shoot for smaller targets when trading a false breakout and use some of the patterns we talked about.
- Price broke above, tested highs and then close below former resistance? Look to trade a break of the reversal candlestick with stop at extreme
- Price broke strongly against resistance level breakout (for our examples)? Think of what makes a good pullback (strong impulse leg) and now look to trade the pullback from the failure.
Knowing what a potential failure looks like when trading breakout is a must! You must strip away all “hope” from your trading and listen to what price is telling you.