How to Use False Breakouts to Your Advantage

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How to Use False Breakouts to Your Advantage

While I do watch for price breakouts, I am always on the lookout for false breakouts…because I want to trade those more. Most traders view false breakouts as a bad thing, a market phenomenon that cuts into their profits or increases their losses. I propose you look at false breakouts as an opportunity. In my opinion, trading false breakouts is actually less risky than trading traditional breakouts. This is because so many people are watching for breakouts, but when the trade goes sour all those traders are clamoring for the exit; that provides a profit opportunity for the trader who held back and can now pounce on the opportunity. Here’s how to capitalize on false breakouts.

What Is a False Breakout?

First off let’s look at a normal breakout. A normal breakout is when the price breaks out of some pattern, whether it’s a range, triangle or some other chart pattern. By drawing lines along areas of support and resistance we can see where the priced had trouble passing through. If the price ends up passing through those prices, preferably in an aggressive fashion, then we have a breakout.

Traders watch for these of breakout moves, and attempt to capitalize on them. Figure 1 shows a breakout to the downside.

Figure 1. GBPY/JPY Downside Breakout

When the breakout occurs most traders will get short or buy puts. In this case the trade would have been profitable. If the breakout had been to upside, traders look to get long or buy calls.

Unfortunately, not all breakouts are as clear cut as the one shown above. Quite often the price moves out of a price range, appearing to be a breakout, but then quickly moves back into the range trapping all the traders trading the breakout.

Figure 2 shows a false breakout. It appears that the price is breaking to a new high (moving past the former high) which signals that the uptrend is continuing, and so traders start getting long/buying puts.

But the price quickly retreats back below the former high (yellow line) and continues to fall. In this case, trading the false breakout is the profitable strategy. Once you realize the move higher is a false breakout, you want to get short/buy puts.

Figure2. GBPY/JPY False Upside Breakout

Figure 3 below shows a false downside breakout. The price moves just below a former low, but then quickly moves back higher, trapping the traders who thought the price would continue to drop. In this case, once you realize the downside breakout is false, you want to get long/buy calls.

Figure 3. False Downside Breakout

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Trade With the False Breakout

Trading false breakouts provides another strategy that you can utilize, as well as offer a way to make back money you may have lost on the traditional breakout trade. Therefore, I like to trade breakouts, but also keep an eye out for false breakouts. If a breakout turns into a false breakout, I quickly close out my original (breakout) trade at a loss, or open a new position in the direction of the false breakout to offset losses on the original trade.

There isn’t a magic formula for trading false breakouts. Just like trading normal breakouts some of your trades will winners and some will be losers. By using a few other trading tactics though, you can potentially bolster your chances of success.

One of the worst things that can happen to a trader is getting caught in a whip-saw, where they go from long to short, long to short and end up losing on all the trades because the market moves back and forth rapidly with no definitive direction. This can happen with breakout and false breakout trading.

To increase the odds of choosing which false breakouts to trade, using an indicator to two can help.

Add either a MACD or Stochastic Oscillator to your chart. In Figure 4 I’ve added a MACD to the trade we looked at in Figure 3.

On the false breakout, notice how the price has dropped below the former low (yellow horizontal line) but the MACD is actually above where it was (upward slanting green line). This is called a divergence; the indicator does not agree with the price action. In this case the indicator is warnings us that the falling price may soon give way to buying pressure, which it does.

Figure 4. MACD Confirms False Downside Breakout

In Figure 5 I have added a MACD to the trade we looked at Figure 2. Once again we see a strong divergence. The MACD is making a lower high even though price is making a higher high. The indicator is once again telling us that this breakout is very weak, and once the price begins to drop off the high we know that it is a false breakout.

Figure 5. MACD Confirms False Upside Breakout

Adding the indicator helps in two primary ways. If you see this sort of divergence occur–where the indicator is not in agreeance with the price movement–it is likely best to skip the traditional breakout trade. Secondly, it signals that you should be on the lookout for a false breakout trade. When the false breakout develops, and you have a divergence, take a trade in the direction of the false breakout.

Trading false breakouts adds another element to your arsenal. Since most traders are looking to trade breakouts, when a false breakout occurs the move is often sharp as traders who use traditional breakout methods scramble for the exits. Just like you shouldn’t trade all breakouts, don’t trade all false breakouts either. Search out the ones that provide the best profit opportunity by looking for divergence on an indicator before making the trade.

False Breakout Strategy: A Simple Yet Powerful Approach

Consider the following scenario.

You’ve had EURUSD on your watch list for weeks. More specifically, you’ve been waiting for a break below a key support level to take advantage of the selloff that’s sure to follow.

After three weeks of practicing saint-like patience and unshakable discipline, the Euro finally sells off against the US dollar and closes below support.

The wait is over!

You open your trading platform, enter the necessary details of the trade and place a limit order. Before you go to bed, you work out what the profit will be one last time out of sheer excitement.

The following morning you awake to find that not only did EURUSD fail to respect former support as new resistance, but it also rocketed 200 pips higher against the USD taking out everything in its path including your stop loss.

The pair goes on to close the day back above your key level, negating the entire trade idea as well as your bearish bias.

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Sure it does. We’ve all been there. Even the best looking trade setups can and do fail on occasion.

But the million-dollar question is, why did this happen?

Better yet, how could you have mitigated the risk or perhaps even benefited from the false break itself?

That’s what you’re about to learn. By the time you finish reading this lesson, you will have a firm understanding of what false breaks are, why they form as well as how to take advantage of them.

Read on to learn about this little-known trick.

What is a False Breakout?

First things first, before you can learn how to use false breakouts to your advantage, you have to know what they are and how to identify them.

A false break, or breakout, as the name implies, is any move (and subsequent close) above or below resistance or support respectively followed by a reversal that fails to respect the broken level as new support or resistance.

Let’s take a look at an example.

Notice how NZDJPY closed above channel resistance on a 4-hour basis but subsequently failed to hold above it as new support.

What’s important to note here is that we’re dealing with closing prices. If a currency pair merely pierces a critical level, it is not considered a false move.

For example, I see a lot of traders incorrectly labeling the two instances below as false breaks.

Whether you consider these false breaks depends on how you define a “break.” For me, a breakout requires the close of a candle, and because I trade the daily time frame 90% of the time, it often involves a daily close above or below the level in question.

If we revisit the EURGBP chart above, the daily candle merely pierced resistance, so to label this as a false “break” is inaccurate as the candle never actually broke (closed above) the key handle.

Now, if you had been trading the 15-minute chart, the decision about whether or not it’s a false break would have been different. Having said that, the technique I’m about to show you is only accurate when used on the higher time frames such as the 4-hour and daily charts.

There is often too much “noise” on the lower time frames to adequately gauge what is a false break and what is not.

This brings us to the next, very important subject of time frames.

Time Frame Matters

The time frame you use to trade and thus identify these false breakouts is paramount to the overall effectiveness of this strategy.

To explain why this is the case, let’s revisit the EURGBP chart above.

The two instances above were clearly NOT false breaks on the daily chart as well as any time frame above the daily. The pair never actually closed above the critical level; thus we couldn’t consider it a false breakout.

But what about the 4-hour chart?

Let’s take a look.

As you can see, while the daily chart never closed above resistance, the 4-hour chart certainly did.

So was this a false break for those trading the 4-hour chart at the time?

Perhaps, but remember that one of the ingredients for any false break is an obvious level of support or resistance. The retest in the chart above occurred after just one other test of resistance.

With this in mind, attempting to trade or even analyze the price action on a 4-hour closing basis would be ill-advised.

To understand why we have to go back to price action trading 101. One of the tenants of trading between support and resistance is that you must know which time frame is respecting a given level or pattern.

In the case of the EURGBP chart above, the 4-hour had not established itself as the predominant period in relation to the resistance level.

To clarify what I mean by predominant, let’s compare it to the ascending channel that formed on NZDJPY.

Notice how NZDJPY touched both support and resistance on several occasions prior to the false breakout. In this case, the 4-hour chart was clearly respecting the pattern and could therefore be used to assess the implications of the false break that eventually materialized.

Any false break is only as valid (and telling) as the time frame on which it occurs.

So which time frame is “best” for using the technique I’m about to show you?

In my experience, the 4-hour and daily periods work the best. However, each situation is unique, so it all depends on which time frame is respecting the key level in question.

Trading Away From False Breaks

Now that you know how to identify these false moves let’s dive into how you can take advantage of them.

Just like the pin bars we use when trading price action, a breakout that immediately fails is a sign of strength or weakness. We can use this to our advantage just like any other price action signal.

In fact, you can’t have a pin bar on the daily chart without having a false breakout on the intraday charts. The same applies to any combination of time frames.

The NZDJPY 4-hour channel below is a great example. Once the pair closed back below the upper boundary of the structure, it was time to begin watching for selling opportunities.

Note that the pair eventually found a bid right where we’d expect – at the channel support that had attracted buyers on three previous occasions.

In summary, we would have looked to sell on a 4-hour close back below resistance with a target at channel support.

Staying Out of Trouble

Remember how I mentioned that you could have mitigated the risk of getting sucked into these traps at the beginning of this lesson?

The best way to do that is through a firm understanding of price action. And that involves more than just pin bars and inside bars.

Allow me to explain.

You may have noticed that shortly after closing above channel resistance, NZDJPY formed a 4-hour bullish pin bar.

Now, you may be asking yourself, why wouldn’t we have traded that bullish signal, which ultimately failed?

Good question. The reason we didn’t commit to this particular pin bar was quite simple.

The pattern in question is an ascending channel and therefore has bearish implications. As such, we would only want to trade a breakout below channel support, which never materialized before the close above resistance.

Technically speaking, the pattern above was a bearish flag as it was the result of an impulsive move lower. That meant that any buying was counter-trend and thus not advisable.

Pro Tip: As a general rule, ascending patterns have bearish implications while descending patterns have bullish implications.

If on the other hand a pin bar had not formed here and the level was a horizontal pivot rather than a channel, we wouldn’t want to trade the breakout without confirming price action.

What is “confirming price action”, you ask?

Simply put, it’s a bullish or bearish pin bar that forms on a retest of the broken level. It adds conviction to the setup and provides a place to “hide” your stop loss.

You won’t always be able to avoid false breakouts. No technique or strategy will keep you safe 100% of the time.

But through the combined use of technical patterns and bullish or bearish price action, you can give yourself the edge needed to make money over an extended period.

Final Words

The false breakout strategy discussed above is ideal for the more advanced price action trader. If you’re just starting out or not yet profitable using the basic strategies taught on this site, you are probably better off sticking with those to first build a strong technical foundation.

Remember that like any trading strategy, technique or concept, the ideas discussed in this post are based on probabilities, not guarantees. So while a false break of a given level can often result in an extended move in the opposite direction, it does not guarantee the outcome as such.

Whether you use these teachings to formulate an outright trading strategy or only use them to assist in your technical analysis is up to you. As I always say, the “best” trading style is the one that works best for you.

As for me, I simply use the technique above as a way to gauge market strength and therefore add conviction to an already established trade idea.

Your Turn

How do you handle false breakouts while trading the Forex market?

Leave your comment or question below and I’ll be sure to respond.

Leave a Comment:

21 comments

Hi, nice article, thank you. but I see why your analysis fail. your trendline are draw wrong way. this is very common. I am trading FX with trendlines for the passed 8 years.
cheers,
Jim

Jim, the analysis didn’t fail. This was a profitable trade for us due to the strategy mentioned above.

You may be referring to drawing the resistance level a bit higher, which could also be true. But as I pointed out above, the bullish pin bar that formed on the 4-hour chart confirmed that the resistance level was positioned correctly.

Hi Jim,
I don’t see any other way you could have drawn that trendline to avoid the falsebreak prior to it happening. Maybe you should illustrate

hi justin…
I think You should try drawing in a line chart. there will be more opinions…
cheers,
paijo sastro

Paijo, I use a candlestick chart so that wouldn’t work. Also, you wouldn’t be able to identify false breaks with a line chart, at least not in the way that I trade/teach.

Hi, its interesting article, where would I put my stop on a breakout of an ascending triangle? If after an impulse move, would it be better to Sell as it enter the channel and place the stop on highest pivot, the RR would be more reasonable?

Roland, it all depends on the structure. Be sure to visit the lesson on rising and falling wedges, which includes details on stop loss placement. https://dailypriceaction.com/free-forex-trading-lessons/trading-rising-falling-wedge-patterns

This article really clear my doubt on ascending and descending flags now I know the real facts k
Thanks a lot for the articles …hope more will come from you.

Taiwo, glad to hear that. Thanks for stopping by.

Thanks for your article. Does false break only happened in channeling? Could it happen on wedge?

Adi, yes, false breaks can occur on any technical pattern as well as any support or resistance level.

Thank you again Justin, for reminding us to look at the bigger picture, the context of the break, and that trading with the trend has a higher probability of success. so helpful to see the flag or wedge in the context of the bigger trend & to trade a break in the direction of the trend.

Another very helpful article, Justin.

In fact; the whole website, member’s area and support is superb.

The best trading investment I have made was joining DPA.

Cheers for the work you put into it.

Hi Justin,
I thought ascending patterns such as triangles were bullish and descending triangle patterns were bearish. Am I wrong?

HI JUSTIN LOOK MAN AM SO PROUD OF YOU MAN ITS MY FIRST TIME TO TRADE PATTERNS . I AM A NEW TRADER I WAS LOST IN THE MIDDLE OF INDICATORS … LOOK DUDE YOU BROUGHT LIGHT IN MY EYES THANK YOU,THANK YOU THANK A MILLION TIMES YOU THE BEST KEEP UP THE GOOD WORK.

Sometimes false breakouts are due fundamentals

Hello Justin, great article, thank you. In your experience what connotations does a false breakout occurring in the normally expected pattern failure direction carry, if any? I.e an upward wedge having a false breakout downwards for example and then re-entering the structure. Thanks again

What do you do in cases were, there a full body candle closes below resistance. Do you then consider that as a break out. This is when you don’t see any pin bars on that D1chart

Hi there I want to know which of the trading sessions is best for executing trades?

Thanks for the explanation on false break out. where do you think the SL will be placed to trade a false breakout ?

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Using False Breakouts to Your Advantage in Day Trading: How to Re…

Breakout or Fakeout? http://www.financial-spread-betting.com/strategies/trading-breakouts.html PLEASE LIKE AND SHARE THIS VIDEO SO WE CAN DO MORE! In this lesson, we look at the various aspects to trading a breakout. A breakout is when a price has been banging away at a support or resistance for a while, establishing the level, but then passes through the level and continues on its way.

It’s obviously great if we can spot this, because we can place a trade to take advantage of the price continuing away from the breakout level. This is one of the fundamental ways to make a trade for profit.

The question is how to determine whether this is a real breakout that will carry on, or if this is a “fake out” which looks as though is going to run away and then returns back behind the support or resistance line. What’s really happening is we need to determine when we’re going to take the trade, when is a good time with a high probability and a minimal loss if it doesn’t go our way.

As mentioned in the support and resistance lesson, once a support or resistance is broken quite often the price will come back and test it from the other side, and the level becomes the opposite, i.e. support becomes a resistance and a resistance becomes a support.

If you choose to place a trade when the price has broken through by a certain distance, you risk it coming back to the support/resistance level and maybe even failing to sustain the breakout. One way to avoid a possible greater loss is to place a conditional trade, a limit order, which will only open the trade once the price does come back to the area of the support/resistance level. When setting the level you must always remember that you cannot rely 100 percent on the actual level, and you have to leave a margin or fudge factor to make sure you actually capture the trade.

You should also have set a stop loss order to terminate your trade if the breakout fails and the price comes back through the support/resistance level.

What have we achieved here? First, if the breakout continues without coming back to the support/resistance level, we do not even enter the trade – nothing lost, nothing gained. If, as we suspect and hope, the price comes back to the support/resistance level but then reverses and continues the breakout, the limit order will enter the trade at the best possible price and produce more profit. If the breakout fails and the price comes back through the support/resistance level, then we have reduced the amount of loss before the stop loss level is hit and the trade is ended.

On the whole, this strategy appears to be advantageous. If the breakout works or if it fails, we maximize profit or minimize loss, respectively. So trading like this can be a good tactic. The circumstance that this ignores is if the breakout happens and the price continues without coming back to retest the level. In this case, we never enter a trade so it’s a missed opportunity.

Trading is not exact, and is different every time you do it. On balance, you may think it’s worth missing some chances for the sake of improving your results when the trade happens.

Related Videos (these are just of the videos we created on breakouts – for more just use the search function on this channel!)
Trading Breakouts: Which Breakouts are Likely to Work Out Best? .

Trading Breakouts: 5 Situations Where You Shouldn’t be Buying a Breakout

A Simple Breakout Trading Rule: Longer Price Stays in a Range = Bigger Breakout ?

Tips for Identifying Real Breakouts! ?

Spotting the Difference between a Pullback and a Reversal? ??

How to Trade Breakouts: A Simple Strategy ?

Using False Breakouts to Your Advantage in Day Trading: How to React to False Breakouts ?

Breakout Trading Strategy: Exiting a Breakout Trade within a Trend ?

Classic Breakout Strategy with a Twist! ?

Trading a Forex Breakout if you’ve Missed the Move ??

Trading Strategies that Profit from Trapped Traders: How To Trade Against the Losing Traders ?

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7 thoughts on “ Using False Breakouts to Your Advantage in Day Trading: How to Re… ”

To UK: I enjoy your educational video: full of truth and reality. These are the type of videos I respect. In essence, this is just managing uncertainty as regarding direction. We do not know where the market or vehicle will travel from one minute to the next. At 7:49 minutes, this bears the veracious fruit.

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