To trade breakouts with confidence, you first need to know how to avoid false breakouts. Breakouts are lucrative for traders because they provide a perfect point to enter and a perfect spot to place stop-losses. However, it is also important to know that breakouts can be risky, in fact dangerous. Because you may become a victim to false breakouts.
Have you ever entered a long position after seeing a key resistance breached but the market turned the other way? Or, you entered a short position after seeing price smashing through support but the market bounced back? Don’t feel bad because it is something that happens to everyone. You aren’t alone who became a victim of false breakouts.
That said, false breakouts hit traders hard when they aren’t expecting. In fact, they catch traders off guard and cause significant losses. Therefore, it is absolutely imperative to know how to avoid false breakouts. Only by knowing and understanding how to avoid false breakouts, can you confidently trade breakouts and make significant gains.
How to avoid false breakouts?
In order to know how to avoid false breakouts, it is important to know the difference between breakouts and false breakouts.
What is a breakout?
A breakout is when prices breach a significant support or resistance level that contained prices at the end of the previous uptrend or downtrend. Prices continue in the direction of the breakout when levels of support or resistance are breached. However, it doesn’t happen all the time. Sometimes the market brings surprises. That is why financial markets are highly risky and highly unpredictable.
What is a false breakout?
Conversely, a false breakout means there is no continuation even after support or resistance is breached. The market turns the other way and that is why breakout is fake. That’s why fake breakouts are dangerous. In fact, the market reverses the direction entirely and moves decisively against traders. Traders who don’t follow proper money and risk management techniques are hit even harder by breakouts. That said, it is absolutely imperative to know how to avoid false breakouts.
How to avoid false breakouts while trading them?
So, let’s get back to the main topic and try to understand how to avoid false breakouts. The first thing you need to know is that it is almost impossible to avoid false breakouts all the time. There are instances when you get caught by fake breakouts no matter how good you are. However, there are a few techniques that can help you minimize the chances of getting hit by fake breakouts.
1. Pay attention to volume and patterns
As we discussed a short while ago that no trader on the planet can avoid false breakouts all the time. It is the market that is in control here and it dictates the overall play. Traders need to observe and see what the market wants. There is no way around obeying the market.
Therefore, it is important to note what the market is saying. That said, pay attention to volume and patterns. The trading volume, on the one hand, is crucial for price. On the other hand, patterns serve as a great guide to predict market direction. Remember that breakout setups appear only after the formation of certain chart patterns. In short, paying attention to trading volume and chart patterns help you avoid false breakouts.
2. Wait for confirmation
The second tip to avoid false breakouts is to have patience and wait for confirmation. When the candle closes and confirms breakout, you can make your move. It is important because you need to confirm breakout strength before entering a trade. So, is it a good idea to set entry orders above or below a support or resistance level to automatically enter a breakout trade? The answer is no, it is in no way a good idea.
3. Looking at different time frames
Perhaps, the easiest way to spot a false breakout is to look at different time frames. For example, if you spot a breakout in a chart of shorter time frames like 4-hour, you should look at charts of longer time frames. When you observe the overall trend by looking at a 1-day or weekly chart and find no traces of a breakout, it means the breakout is false.
4. Avoid chasing strong moves with little or no pullback
Traders often get themselves caught in false breakout when they chase strong moves with little or no pullback at all. Such big bullish moves take prices really high and eventually the market reverses. Why does it happen? It happens because there is no floor or support level to keep those prices high. Conversely, prices that don’t exhibit ballistic moves and retrace from time to time, don’t dramatically fall. Why so? Because such moves have strong floors to keep prices high. In such moves, when prices begin to fall, they soon find a support level where buying pressure moves prices higher. In short, strong moves that take prices really high are often false breakouts. When the bubble bursts, prices fall dramatically and traders incur huge losses.
5. Consolidation before a breakout
Another viable strategy to avoid false breakouts is to wait for consolidation before a breakout. If the consolidation appears, it means both buyers and sellers have no idea in which direction the market will move. The more an asset consolidates, the more traders join because they have more time to place orders. So, it is near a perfect setup for you as well to enter the trade. You can place the stop-loss below or above that consolidation zone.
6. Avoid breakouts without consolidation zone
Another viable tip to prevent from falling into a false breakout trap is to avoid breakouts that occur without forming a breakout zone. Why so? Because price may drop to the breakout level again if there is no consolidation prior to the breakout. It may happen because traders don’t get enough time to book profits and initiate a new trade. As a result, the price drops down to the breakout level.
7. Don’t chase big breakout candle
You will be surprised to read it and ask yourself why I shouldn’t chase a strong bullish trend? Let me tell you why not. Because where will you enter the market without confirmation? Secondly, if there are a lot of short-sellers who book their profit after a strong run, the prices will decline. Therefore, it is crucial to avoid the chase of big breakout candles.
How to avoid false breakouts – the wrap-up
There is no slightest of doubt about the huge profit potential breakout strategies have. That is why most traders remain ever ready to enter trades at breakout. However, the market may take a turn back even after a strong breakout. This is a false breakout and it causes huge losses for traders who fall prey to it. Therefore, it is absolutely imperative to know how to avoid false breakouts. Fortunately, there are a few tips and tricks to avoid and even trade false breakouts. You need to understand those tips and follow them. They will help you avoid false breakouts.