Dealing With False Breakout, Few Things You Must Learn

Trading is one of the most rewarding professions in the world, but it can also be one of the most depressing and mentally difficult if you do not trade properly. To become a successful trader, one needs to have a trading strategy, discipline, proper money management techniques and self-control in the market. However, apart from the aforementioned traits, one more key trait which will help you to become a successful trader is to know when not to trade or which trades you should give a miss.

As the quote succinctly puts it: “Successful traders need to know when to be in a trade; They need to know when to not be in a trade”.

Indian market since the beginning of the calendar year 2017 has witnessed a decent run-up and delivered good returns in a short span of time. During this period, we often hear about the term ‘breakout’ from traders and during this merry period, traders would have fetched handsome profits. An astute trader waits for the breakouts to catch the trend and this strategy looks amazingly simple, isn’t it? The impulsive trader places his buy-stop order just above the crucial resistance level. If the breakout happens, the order gets filled and a long position is opened. However, there is opposite side of the coin also: one of the disappointing encounters is the false breakout. It frequently goes ahead on the heels of an immaculate value activity design that appears to have everything putting it all on the line. You set your buy-stop orders, the orders get filled, but before you know the price has fallen back inside the aforementioned pattern and now you are confronting a potential misfortune. 

WHY DOES THIS HAPPEN? EVEN BETTER, HOW MIGHT YOU AVOID THE DANGER OF A FALSE BREAKOUT? 

That’s exactly what we are going to talk about in this article. We will try to cover the characteristics of a false breakout, why they occur as well as what you can do to protect yourself. 

BEFORE WE MOVE ON, LET US SEE WHAT IS A BREAKOUT AND FALSE BREAKOUT?

In the illustration, the security has formed a triangle pattern. As the consolidation became tighter, the security broke to the upside and maintained bullish momentum to hold above the breakout level. Hence, this is a perfect set-up of genuine breakout.

What is a False Breakout: A false breakout, also called a ‘failed break’, is a price movement through a support or resistance level that lacks the momentum necessary to maintain its direction. In other words, the market fails to produce enough supply or demand to validate the break of a key level. 

In the illustration, the security has formed a triangle pattern. As the consolidation became tighter, the market broke to the upside, but was unable to maintain enough bullish momentum to hold above the level. In other words, the market lacked the demand to push prices higher after the breakout occurred.

If you would have taken a long position as soon as the market breached the resistance level, you would have been caught in a false breakout. Once in a trade like this, you are confronted with two options-either stay in and ride it out, or exit for a small loss. Neither of the two options sound very appealing. We all know that nothing is sure when it comes to trading in the stock markets. We also know that there is no way to completely avoid losses. But what if I told you that there is a way to reduce the likelihood of experiencing a false breakout?

Notice the illustration. The stock formed a key resistance area around the level of Rs. 405-406, and recently the stock managed to move above the level of Rs. 405-406 and registered a fresh high of Rs. 412.65. However, the stock was not able to maintain enough bullish momentum to close above the level and formed a pin-bar with large upper wick. Traders who simply placed a buy-stop order above the resistance level of Rs. 405-406 would have experienced a loss or at least a considerable amount of stress as they watched the stock's price move against their position.

WHY DOES THIS HAPPEN?

Times have changed and especially the technology has advanced so much that every data we need is available on a single click. In the markets, most traders use pre-defined set-ups for trading and their methodology remains the same, i.e. buy the breakout and ride the trend. The market makers create enough trades to push the price above the crucial resistance level or above the recent highs of the security. Due to the orders being stacked little above those levels, the price gets attracted to the magnetic bunch of buy orders which then gets triggered and pushes the trader further. This is the level at which the market makers make a smart exit, leaving the price movement waning back or collapsing to the original position. This action of the market makers leaves a spike behind on the price movement chart. Market makers do this many times every day.

Look at an ideal breakout.

The above chart is of Ceat on the daily time frame. In the above chart, the stock faced resistance around downward sloping trendline which are highlighted by arrow marks. However, as the stock moved above the downward sloping trendline, it witnessed a breakout. What’s important for trader to understand over here is that the stock managed to close above the downward resistance trendline and the trader who would have taken the position would have experienced a nice gain on this trade. The key point over here is that by simply waiting for a close above the level, we can confirm the strength of a breakout, giving the set-up a greater chance of succeeding. After looking at the above chart of Ceat, the million dollar question is “How do I know what type of breakout I’m trading” Of course, we will never know with cent per cent accuracy, but there is an important checklist that helps a trader to determine which breakouts have a higher chance to follow through.

IMPORTANT CHECKLIST:

High Time Frame Breakouts Work Better: This is perhaps the most important checklist when it comes to reducing the chance of a false breakout. As a general rule, anything above the one-hour time frame works the best. Most preferably, breakouts on the four-hour and the daily charts are the best for trading. For beginners, a daily breakout would be convincing, because higher time frames generally produce the most reliable set-ups.

Follow The Trend: It is always said that traders should go with the flow. Market sentiments or trends play a crucial role for successful trading. Hence, it is important to know the trend of the market. Following rules helps to reduce the chances of trading on a false breakout:

1. If the market structure is bullish: Take long breakout trades.

2. If the market structure is bearish: Take short breakout trades and

3. If the market condition is not clear: Avoid trading any kind of breakout.

DEFINE THE RIGHT SUPPORT AND RESISTANCE LEVELS:

There are number of methods to define the support and resistance levels. What’s important for a trader is to define these supports and resistances with a proper methodology. Always remember a Head and Shoulder formed at the top is more likely to be successful than that which is formed at the bottom. This is because Head and Shoulder is a trend reversal pattern and, hence, prefer a breakdown of neckline support for trading if the pattern is formed at the top. Likewise, a breakout of three-point touch trendline is more reliable than a two-point touch trendline. Hence, it is important to identify right set-ups and trade accordingly.

PATIENCE

It can be challenging at first to wait for several hours or even days to confirm a breakout. For most traders, the challenge is born out of the apprehension of missing out on a trade. If you ever feel this fear creeping into your mind, just remember that there are often multiple opportunities to enter a breakout set-up. In fact, the market will often re-test former support or resistance after the breakout, giving you a great opportunity to enter the market.

ADD RELIABLE INDICATORS

As a technical trader, you know that it all comes down to probabilities. The more factors you have in your favour on any given set-up, the greater are the odds in your favour that the set-up will result in a profit. Hence, adding a couple of reliable indicators to your set-up may reduce chances of being trapped in a false breakout.

CONCLUSION

Breakout trading is one of the most popular methods of trading followed by short term traders. However, we often come across breakouts that failed and we may lose our hope and faith in trading. However, the checklist given above may provide you with an edge to determine which breakouts are reliable ones and which ones should be given a miss. Hence, next time you trade a breakout, make sure you are increasing the probability of winning by following the checklist.