A breakout trading strategy aims to capitalize on strong directional price movement following a period of consolidation. However, not all breakouts result in lasting trends. False breakout occurs when a price breaks out of a range, but quickly reverses back inside instead of continuing the emerging trend. Learning to spot false breakouts is a critical skill for traders. This guide covers everything you need to know.
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What is a False Breakout?
A false breakout happens when the price of a financial asset breaks above or below an identified trading range, but fails to continue moving in that direction. It is considered “false” because it initially appears like a valid breakout but lacks follow-through, and the price action reverses course shortly after making the breakout move.
For example, if a stock has been trading between support at $90 and resistance at $100 for the past month, a break above $100 would signal a potential upward breakout. However, if the price only spikes to $102 before reversing lower back inside the range, this would be considered a false upside breakout.
Key Differences Between False Breakouts and Real Breakouts
There are a few key characteristics that differentiate a false breakout from the real thing:
- Duration – A real breakout will exhibit strong momentum that continues steadily in the breakout direction. False breakouts quickly fail and reverse.
- Volume – Real breakouts usually accompany a sharp spike in trading volume as new money flows toward the emerging trend. False breakouts show weak volume.
- Range extension – Valid breakouts will make a new range visible outside the previous trading zone, while false breakouts lack range extension.
Identifying these differences requires analyzing the price action context around potential breakout levels.
How to Spot False Breakouts
Here are three simple techniques traders can use to avoid false breakouts:
1. Wait for the range extension
The simplest way to determine if a breakout is false is to wait and see if range extension occurs. If the price fails to make a new range outside the previous trading zone, it increases the odds that a reversal is likely.
2. Consider volume confirmation
Monitoring for an increased volume of breakouts can clarify the validity of the move. A lack of heavier trading volume hints that there is little conviction behind the breakout.
3. Watch for candlestick reversal patterns
Candlestick chart patterns like doji, pin bars, or engulfing patterns help highlight potential trend reversals. Their emergence shortly after a breakout provides warning signals of a false move.
False Breakouts Occur Across All Time Frames
False breakouts can occur on any timeframe, from the 1-minute chart all the way up to the weekly or monthly timeframes. Typically, the shorter the timeframe, the more whipsaws and false breaks occur.
However, due to the higher volatility and noise in short timeframe charts like the 1-minute or 5-minute charts, these false breaks do not provide enough context to be highly tradeable. Analyzing daily or weekly charts provides more clarity for spotting clean setups.
The most tradable false breakouts happen on the daily or weekly charts – these time frames reduce noise while still providing decent signals.
False breakouts are a very common occurrence in the financial markets, but they don’t need to harm trading performance if properly identified. By analyzing volume and price action context and monitoring for candlestick reversals, traders can reliably spot false breaks and avoid poor entry signals. Applying patience and effective confirmation techniques ultimately leads to improved trading results.
What are the most common trading instruments that experience false breakouts?
False breakouts occur most frequently in volatile instruments that tend to range like forex currency pairs, commodities, and cryptocurrencies. Breakouts across stock indices and equities also face failures regularly.
What time frame is best for trading false breakouts?
The daily or weekly timeframes provide the cleanest signals for spotting and trading false breakouts. Intraday timeframes have too much noise. Higher timeframes reduce noise and provide high-probability setups.
Can you avoid all false breakouts in trading?
No trader can avoid all false breakouts – they are an inevitable part of trading in any market. The key is having effective confirmation filters in a trading plan to identify the high-probability setups.
Is higher volume always a reliable confirmation for valid breakouts?
Higher volume confirms increased interest, but there are no absolute guarantees when predicting future price action. Have patience and allow the price action to play out before determining the validity of a potential breakout.
What is the minimum price move needed to qualify as a breakout?
There is no universal minimum price move or percentage criteria. The width of the previous range provides context for a suitable breakout size. Bigger ranges require larger thrusts to overcome resistance or support.