First up, I am a once failed options trader trying to learn trading from scratch. This article on how to identify false breakout is my attempt to understand the concepts behind price action and to stay safe from entering wrong trades. Although this article may not contain all the trading knowledge, it will most definitely be super helpful for trading beginners as that’s the entire intention behind this post.
Please Note: Trading is inherently risky, these notes are for my self-reference. If you’re going to follow them, do it at your own risk.
What is a false breakout?
Most price action traders trade the breakout trades. They plot a resistance and support level where normally the price tends to reverse its direction. The basic principle behind this is that once the price breaks the support or resistance level, it will continue to follow the same direction instead of taking a turn.
False breakouts occur when the price seems to break these support and resistance levels, however, reverses its direction completely to no longer follow the same direction as it normally should.
False breakouts trap a lot of retail trades and I’ve been one of them. Identifying the reason behind these false breakouts, and creating strategies to avoid taking trades in them is a useful technique to keep in your trading arsenal. Let’s find out how to do that.
Why does a false breakout happen?
When the price moves towards resistance or support, the emotional amateur trades tend to think the price will keep moving in the same direction and give a breakout. They enter the trade only after the price has given a significant move and because of this, the price moves a little in their direction on entry only to reverse sharply and hit their stop loss.
Professional traders on the other hand look out for these kinds of false breakouts and use them to gain a better entry position with a better risk-to-reward ratio.
Key Idea #1: Look for volume
Checking the volume of the breakout candle can at most times help you stay away from false breakout. The breakout candles having higher volume than the normal volume level are more than likely to sustain the momentum and keep racing forward.
Key Idea #2: Wait for confirmation
Normally, if the breakout candle is a false breakout, the following candle will most likely be a red one. If it’s still green then odds are high that you’re entering at the right breakout. So if you think it’s a false breakout, please check for confirmation.
Aggressive risk management techniques like strict stop-loss can help avoid these kinds of bull or bear traps. Emotional decision-making can take over if you don’t have a strategy for these circumstances. I lost a fair amount of trading capital until I learned the importance of proper stop-loss.
#Key Idea 3: Observe the breakout candle
Candles with long wicks or a Doji candlestick giving the breakout is a warning sign. Long wicks indicate the indecisiveness of the market. A Doji candle is one in which the open and close prices are almost the same.
Technical analysts see Doji candles as a sign of reversal. You may use a Doji indicator in your trading chart platform in order to get informed of potential trend reversals in breakout trades.
Intraday trading requires a gambling mindset. Once you identify a key support or resistance zone, you decide on a stop-loss and just enter the trade when you see a breakout. If it turns out to be a false breakout, let your stop loss get hit. Once it does so, go ahead and enter in the reverse direction. It does not matter if you’re right or wrong. What matters is if you make money or not.