False Breakouts Are Key Trading Opportunities
Cory Mitchell, CMT
You come up with a trade idea based on an important technical level. It might sound something like this: "If the CAD/JPY can break above the daily chart resistance level of this big triangle pattern, it will likely advance 300 pips or more over the next one to three months." [The timeframe or size of the pattern doesn't really matter, the concept works the same on all timeframes.]
It's a big pattern, so lots of people are watching it. The price breaks above the pattern and starts to fly higher. It moves 50 pips above the pattern but then starts to tank. It moves back into the pattern, dropping below recent swing lows.
New traders are frustrated by this, blaming manipulation, algorithms, or stop hunters. They are angry or sad they lost (or didn't make a big profit like they expected), and don't realize a real opportunity to make their money back is staring them right in the face.
False Breakouts are Often Tradable
False breakouts are a gift! Yes, there is often a losing trade associated with a false breakout, but there are losing trades for lots of people! That's the false breakout's power. When a false breakout occurs, a portion of traders are trapped in losing positions. They need to exit, helping to fuel the price in the opposite direction. Couple this with the fact that those without positions (or longer-term positions) just saw the price try to move one direction and fail. Their conviction and position size is likely to increase in the opposite direction. So a failed rally results in hard selling, for example.
Many traders are so focused on one trade, and trying to make money on that one idea, that they miss the power of getting into a trade in the opposite direction when an idea doesn't work out.
I don't reverse my position every time there is a false breakout, but when conditions are right it can work out well.
I used the CAD/JPY example above because recently the CAD/JPY had a beautiful and profitable false breakout to the upside. In CAD/JPY Near Breakout I discussed the pair moving above what I thought was a key level. The price ended up consolidating around that key level for some time (red box on the chart below). The price then broke to the upside. This made everything look really good for a further upside move. On a good breakout, the price should have run aggressively higher, and any pullback should have stalled near 83.70 or above.
Instead of making a strong advance, the price stalled quite quickly and reversed lower. It moved back into the consolidation, without slowing down. It then dropped below the consolidation. With stop losses placed in this location, most who went long would have already gotten out with a small profit or loss, or have their stop loss triggered below the consolidation. The price then continued to decline.
By the time the price reached 83, or even 83.60, a trader could be thinking "The upside breakout failed and there is potential for the price to continue lower. Is there a valid trade to the downside?"
The trader would then assess their outlook, consider the reward:risk of the trade, and determine if switching to a short position makes sense. It may, or it may not.
Another Way to Use False Breakouts
Another option is to always to wait for a false breakout in the opposite direction of the direction you want to go. There is a trade-off here. Since you wait for the false breakout, you are unlikely to take a loss making a trade ahead of a false breakout. And false breakouts occur quite frequently. The flip-side is that you may miss out on strong moves that breakout and just keep going (no false breakout in the opposite direction beforehand).
In BoE Rate Decision Thursday I indicated that if the Bank of England held interest rates steady, the EURGBP would likely decline. I also know that most traders are backing away ahead of the interest rate announcement instead of taking aggressive positions. So it seemed odd when the price of the EURGBP broke above a 2-day swing high on a sharp rally, only to halt and then drop back below the high. That was a shorting opportunity for a day trader, especially considering that the BoE announcement was still a few hours away.
If you were looking for an opportunity to get short, a false breakout to the upside was an ideal time to do it.
The false breakout to the upside resulted in a hard selloff back into the middle of range, providing a favorable reward:risk trading opportunity. While the price continued to sell-off following the announcement, holding through it is a gamble, so the trader could have taken their profit prior to the big news-related selloff.
Working False Breakouts Into Your Trading Plan
Every trade taken should be a part of your trading plan. This article is meant to simply spark the idea that false breakouts can be tradable. The next step is to start looking at when you will trade false breakouts, and under what conditions. Where will you enter, take profit, and place stop losses. Once you establish these things, include them in your trading plan so you can start practicing these trades—potentially in a demo account with a very tiny position size to start, until your strategy is profitable.
Typically, the more convinced I have a trade will work out—because everything looks so good—those are often the trades that have the biggest false breakouts and moves in the opposite direction (IF a false breakout occurs). If you are convinced a trade looks awesome, probably lots of other people are thinking the same thing.
In trading, if the stars align but the price doesn't do what you expect it to, get the hell out. The price is probably going to move hard the other way. This isn't a rule, but a pretty good guideline.
I will trade false breakouts against my original opinion, but only if there is lots of room for the price to move. For example, if the price is moving in a big channel, and I expect an upside breakout, I will take a short if the price has a false breakout to the upside..like the CADJPY and EURGBP examples above.
My favorite trades are when there is a really small false breakout in the opposite direction I want to go. For example, I want to go long on a consolidation breakout. The price drops below the consolidation (I am not in this trade because I am waiting to go long) and then rallies above the top of the consolidation. These trades have a slightly better chance of working out because the price already tried to go lower and couldn't. I have more conviction that the price will rise as expected (relative to if there was no false downside breakout).
By Cory Mitchell, CMT. Join me on Twitter @corymitc.
Disclaimer: Nothing in this article is personal investment advice, or advice to buy or sell anything. Trading is risky and can result in substantial losses, even more than deposited if using leverage.