False breakouts frustrate many new traders. Pros know they are a part of trading and a huge opportunity. Here’s how to use them to your advantage.
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, and either does the asset being traded. The concept works the same on all timeframes and in all assets.
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 loss 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 it’s not just you. Lots of people are losing on that false breakout! 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. Those without positions (or positions opposite to the breakout) just saw the price try to move one direction and fail. Their conviction and position size is likely to increase in the failed breakout 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.
CAD/JPY had a beautiful and profitable false breakout to the upside. The pair was moving above 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.
Charts from TradingView.
Instead of making a strong advance, the price stalled quite quickly and reversed lower. It dropped back below the prior consolidation (red box) without slowing down. With stop losses placed in this location (below the red box), most who went long would have already gotten out with a small profit or loss, or would see 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. Is there 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.
Below is another example. The GBPUSD had been chopping around. It moves above the prior swing highs then collapses. Another false breakout occurs at the bottom of the range. The price drops below the prior low, but then quickly rallies back to the upside.
Using False Breakouts to Confirm Trade Ideas
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, usually during an uptrend, on a consolidation breakout to the upside. The price drops below the consolidation (I’m not in this trade because I’m waiting to go long on a breakout to the upside) 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). This is especially powerful during a trend.
False breakouts aren’t always at major levels. As discussed above, a false breakout can occur on a consolidation. It can also occur near a recent swing high or low during a trend.
Let’s say you’re interested in getting long in a stock. The price has been rising, then it declines into a pullback. It bounces a bit and then the next decline just barely drops below the prior swing low before bouncing again. Since the price was barely able to push to new lows, that tells you the sellers may be losing momentum. You don’t need to buy right away, but it is a piece of evidence to start watching for a long entry. See How to Spot Trends And Reversals Using Price Action for more on this topic.
Check out the following chart. The stock was forming a half cup and handle pattern. As the handle formed, we can see selling momentum falter when the price barely dropped below the prior swing low and then quickly bounces. The price then consolidates, breaks lower, but then quickly snaps higher again. These two false breakouts to the downside helped confirm the long trade the overall pattern was signaling.
False Breakouts Around Events or Economic Situations
False breakouts can also be used around news or economic situations. If you have a bias toward a specific event triggering the price to move a certain direction, you could wait for the price to make the opposite “fake out” move, and then when it moves the direction you expect, pounce. This approach has the added benefit of potentially keeping you out of a trade if your bias is wrong. If you think a news event should move the price up, you will be waiting for a false breakout down and then a rally up before getting in. If the price just keeps dropping though, you saved yourself from buying and a losing trade.
During a BoE Rate decision I concluded 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 announcements 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, well before the major news announcement, 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, the false breakout to the upside was an ideal time to do it.
The false breakout higher 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 short would have been exited prior to the announcement.
Should You Always Wait For or Use False Breakouts?
As discusssed above, sometimes a false breakout can provide us more conviction for a trade. Or it may present a new opportunity.
Since false breakouts seem to be helpful, you may think “Why don’t I always wait for false breakouts before taking a trade!?”
You very well could! But there is a trade-off. You may miss out on strong moves that break out and just keep going (no false breakout in the opposite direction beforehand). And false breakouts don’t always work out either. We may get a false breakout, and then the price keeps moving in the original breakout direction: the false breakout is false.
Ultimately, the choice is up to you. I don’t personally always wait for false breakouts, but if the direction is unclear, or I need more evidence to signal a trading opportunity, a false breakout may provide me with that. So I use them sometimes, but don’t require a false breakout before every trade I take. When a stock or forex pair is moving very strongly, it typically just runs and won’t have a false breakout beforehand.
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 and helpful.
The next step is to consider when you will trade false breakouts, or use them to your advantage, 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 am 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. IF it doesn’t work out, lots of people will be trapped which means a hard move the other way.
In trading, if the stars align but the price doesn’t do what you expect it to, get out! This isn’t a rule, but a pretty good guideline.
By Cory Mitchell, CMT.
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.