Most novice day traders have a major pet peeve: false breakouts. A stock, forex, or futures contract looks set to move one direction following a breakout, they jump in, then the price quickly reverts course, stopping them out or putting them in a losing position. Frustrating and costly! But it doesn't have to be. Switch your mind frame from the victim ("Big traders and brokers are manipulating the price") to opportunist ("False breakouts provide one of the best, low-risk, high-probability opportunities around!"). Here's how to do that, and a strategy for capitalizing on false breakouts.
False breakouts can let you capture profits on an easy-to-spot pattern.
They should be part of a written trading plan.
Use them with caution and they can become your trading friend.
Your Psychology and False Breakouts
When you start trading, one of the first strategies you often learn or feel compelled to trade is a breakout strategy. Whether it's a breakout from a range or another chart pattern—such as a triangle or just a small price consolidation—the idea behind a breakout strategy is to capture a big move following a pattern that is easy to spot.
Trading breakouts can work, but be prepared to experience many false breakouts: the price breaks out of the pattern, only to revert right back in. If false breakouts are frustrating you constantly, the market is telling you something. Why not trade the false breakout instead of trading the breakout? If you are constantly losing money because of false breakouts, could you make some money trading alongside the traders who are taking it? You can, and it's a great strategy, though it requires practice, focus, and quick reflexes.
Not All False Breakouts Are Equal
False breakouts occur regularly, on all time frames. Not every false breakout is worth trading. False breakouts are best traded in the direction of the trend. For example, the trend is up and a triangle pattern develops. The price breaks slightly below the triangle, only to quickly jump back in. That's a trade you want to be long (buy) because the trend dictates the price is likely to move higher. A false breakout to the downside adds evidence to that conclusion (if it can't go lower, it will try to go higher).
False Breakout Strategy
As an example, a tick chart of the S&P 500 E-minis (ES) shows the price moving higher, pulling back (higher low), and then moving to the same point as the prior high. As the price starts pulling back again, an experienced trader's internal dialogue is strategizing what to do before the trade even occurs:
"The trend is up, but we are in a potential range or possibly a double-top chart pattern scenario. If the price continues to decline below the prior swing low the trend is likely transitioning to the downside and we don't want to go long. BUT, if the price pauses at or moves only slightly below the prior low, and then rallies sharply back above the prior low, buy quickly!
Set a stop loss just below the new low, and monitor conditions for when to exit a profitable trade. If the price is moving sharply higher, see if it breaks out above the prior high. If it pauses near the top of the pattern, exit immediately."
The strategy is simple, but it takes practice and focus to implement it. False breakouts occur quickly and try to draw you into trading the breakout. Be patient. Strategize in your mind:
- What is the trend direction? That's the only direction you trade in.
- What would create a false breakout (in the opposite direction of the trend)? If that scenario occurs, how and where will you get in? Will you use a limit order or market order, and how far does the price have to move back into the pattern?
- Where will your stop loss be?
- Where will you get out of a profitable trade?
Answer all these questions in your mind as the trade is potentially setting up. That way, if the trade does occur, then you can take it without hesitation, and know exactly what to do.
The strategy should be written down in your trading plan, though even when you know it well, reiterate to yourself (answering questions above) exactly what you will do if a trade develops.
Considerations and Final Word
How far the price moves back into the pattern for it to be considered a false breakout depends on the market being traded and the "context" of the trade. On a very volatile day, the amount the price needs to move back into the pattern will be larger than on a day where volatility is very low.
Also, assess the quickness and depth of the breakout. If the price breaks a long way out of the pattern (about one-quarter of the pattern size or more) and then moves back into the pattern slightly, don't trade the false breakout strategy. A false breakout should be relatively small and short-lived for trading purposes.
The risk is relatively small on these trades (a difference between entry and stop loss) so don't get greedy with the target. Hold the trade until momentum wanes. This may be near the opposite side of the pattern, or you may hold for a breakout in the trending direction. Exit if a false breakout occurs in the opposite direction of your trade.
The strategy works well because you are only trading false breakouts which align you with the dominant trend. You can still trade normal breakouts in the direction of the trend (which are more likely to work out anyway).