The following article on False Breakouts is the opinion of Optimus Futures.
Traders often fear of taking a loss on seemingly clear technical trade setups like breakouts. It is not hard to imagine an emotional spike when an exciting wedge breakout that you expect to run for a while reverses on you leaving a promising trade hitting or nearing the dreaded stop loss.
However, to thoughtful traders, false breakouts are more than just notorious track record hindrances. They are a crucial and critical gauge of market sentiment. In fact, when understood thoroughly, false breakouts alone have the potential to take center stage in highly reliable trading methods.
In this article, we explore the false breakout phenomena and dissect their crucial role in determining market sentiment and signaling market direction.
Why do False Breakouts Occur?
False breakouts in the market are just as common – if not more common – than actual breakouts. You will have a better understanding of why they occur when you take a step back to study the nature of financial markets in general and the types of people who participate in it.
At a rudimentary level, market players (or traders in general) can be categorized as either retail traders or institutional traders. While larger in volume, retail traders are often not as resource-laden or capitalized as institutional players who may be fewer in number but by-and-large have an upper controlling hand in the market.
Most financial markets like foreign exchange markets and some liquid futures markets are large enough to make dominance by a single institutional player near impossible. However, as a group, these institutional traders can have a commanding say in where the market finds the price equilibrium. And this is where things get more interesting from the perspective of false breakouts.
With their respectively larger resource base, institutions and their representative traders are presented with an interesting problem. Their larger trade volumes often require substantial liquidity in the market, and with most institutional traders having this same problem, their trading activities will often correlate, creating the meaningful ‘group’ impact we talked about a short while ago.
It is therefore very common for institutional traders to be selling when they have a logical reason to expect most retail traders to be buying (and vice versa too). Retail traders will quite literally ‘buy into the orders’ of these larger sellers, and of course, with increased selling pressure, prices will push back down, even though technical or even news-driven reasoning might be indicative of prices to head higher.
With this understanding in mind, it should not be hard to fathom why breakout setups, where a large volume of buy or sell orders is expected to come into the market will often be targeted by institutional traders, eventually printing the notorious false breakout on the chart.
False Breakouts in Action
We will now look at some false breakouts in action, as we try to put theory into practice.
The above chart is from the 10 year Treasury note futures market back in June 2016. Initially, we’d like you to focus on point 1 on the chart, which represents a conspicuous swing high – that is a price level that price sharply backed off from in the past. This is indicated by the red dotted line on the chart.
Now we look at point 2 on the chart. This is where a lot of retail traders would likely begin to get excited about a breakout as prices rise sharply into the level. Bear in mind that prices will normally not only rise due to increased buying pressure but sometimes also due to a lack of selling pressure.
At point 2 on the chart above, we likely have a case of reduced selling pressure more than an increase in any kind of buying pressure. Any buying coming into the market at this point is likely uninformed bullish breakout traders wanting to push prices above and beyond the swing high marked with the red dotted line. These buy orders will serve as much-needed fodder for sellers as you will see in a moment.
As the market moves to point 3 on the chart above, you will notice how we have a sharply rising bullish candlestick that actually pushes past the swing high at point 1. At this point, the trap is well set for more retail buyers to come in who may perceive this as a true breakout opportunity. Interestingly, this also ripens the moment for sellers to start unloading their larger bulk orders eventually overturning the market.
What’s more, as prices push back under the red dotted line it may trigger a panic-strike from traders already long on the initial breakout. As they close their long orders (square the trade-off by selling) it only adds to the selling pressure that at this point is clearly dominating the market.
Point 4 on the chart above reflects a textbook ‘retest’ phenomena that we usually see after true breakouts, but one that is not uncommon with false breakouts as well (consider the right shoulder of a typical head and shoulders pattern). As the market continues to use the swing high as resistance, it will ideally re-test the level before finally dropping for a more sustained move/trend.
We will look at a vice versa case now:
Here we have the Light Crude Oil futures market back from March 2015. As you will read through the annotations on the chart, it reflects pretty much the same underlying dynamics as the earlier example that was elaborated more in detail, except that we’re missing the corresponding ‘point 4’ here which would have been a retest of the support level drawn with the red dotted line, past the false breakout instance. But you get the point.
How to Avoid False Breakouts
You may have noticed that a fundamental development related to false breakouts in both the examples above was the sharp accelerating move into the swing high / low just prior to the false breakout.
Looking out for prices rising or falling sharply into key support and resistance levels horizontal or angular (trend lines that is) is hands down one of the most important aspects to avoiding getting caught in the false breakout trap.
Here we have Light Crude oil futures from December 2015 presenting a true breakout of a former support area. Notice how price moves gradually to the level with periodic bouts of brief buying coming in the market before price eventually pushes past the swing low. This should be seen as a sharp contrast to the false breakout situations above where we have prices sharply rising or falling into the level.
You will also see that these minor pullbacks prior to price hitting the swing low or high serve as important short-term support and resistance levels that will bolster price in the direction of the breakout. In the example above, notice how price momentarily bounces off the support area but is sealed off at the resistance created by the shorter term swing low just prior (the Gold horizontal line).
Another way to safeguard against losses on breakout setups is to ideally wait for the initial breakout and retest of the level before pulling the trigger on the trade. For example, as price breaks out of resistance, it might not be as safe to go long at that point, as it would be if you were to wait for price to pullback again to the level with profound evidence of support at that level – thereby confirming that the level has flipped from resistance to support.
If you study the example above, you will see the exact moment when price pulls back to retest the former support at the swing low (marked in red) as resistance before plunging down again.
The flipside to this is that every breakout does not lead to a pullback and you risk missing the opportunity altogether. Bear in mind though, that the exact anxiety from the thought of missing the opportunity itself is what causes most retail traders to be crushed by false breakout activity in the first place. Many retail traders try to jump their trades on initial breakouts while prices ‘look’ to be favoring a sharp profitable move in the direction of the breakout only to find the hard way that their impatience did not help them.
Part of being a successful trader calls for being patient and looking for as many confirmations and favorable odds as possible before pulling a trade entry trigger and in this case, avoiding false breakout traps.
There is a substantial risk of loss in futures trading. Past performance is not indicative of future results.
