The Underlying Mechanics of Real Market Breakouts

Part I of this post described the types of false breakouts and the situations in which a breakout is most likely to be a good trading signal. This post on breakouts will focus on the differences in price action you see with real vs. fake breakouts, and the underlying mechanics of this price action. It will help you differentiate between genuine and fake breakouts in real time. Part III of this post provides detailed advice on how to trade breakouts to maximize your chances of a winning trade.

Almost all breakouts start with a fake breakout—a push through a high or low or formation top or other barrier or resistance that is followed by a fast retreat. The main sign of a real breakout is that the retrace is brief, maybe only seconds. The retrace gets bought or sold fast and the price quickly surges beyond the high or low of the first breakout attempt.

Then, on this second breakout, the price tends to keep moving. It tends to have a melt-up feel—the price candles involved are large to match large volume bars. If the price candles are small when the volume bars are big it means sophisticated traders are unloading inventory into the breakout trading. You don’t want to see that—it means you’re more likely to get stuck with a wrong-way bet. Long candles with big volume bars mean a market maker is getting stuck. That’s what you want to see.

When evaluating whether to bet a breakout, it’s helpful to keep in mind the underlying reason for the difference in the price action between real breakouts and fake breakouts. Real breakouts are characterized by unusually one-sided buying or selling. This puts market makers (whether human or high frequency trading bots) in danger of accumulating a lot of unwanted inventory (shorts when the price is moving up, or longs when the price is moving down). Because market makers’ risk-bearing capacity is limited, they will start to increase the bid-ask spread when their inventory levels get high. This means, in an upward breakout, that they are essentially jacking up the price to try to attract some other sellers. In a one-sided downward move, they start rapidly lowering the price to try to unload some inventory to other potential buyers. The reality is more complex, but this gives you the gist of it.

Essentially, when market makers are getting stuck with unwanted inventory it leads to lower liquidity, and this is why you tend to see surges or plunges on real breakouts. It’s this same loss of liquidity that can also lead to crashes on big one-sided downward moves.

If you google “how market makers manage inventory” you’ll find research papers from the Fed, the Bank of Canada, and various academic institutions that document how market makers respond to one-sided market action. You may find “Market Maker Inventories and Liquidity” a good start if you’d like more information.

See Part I of this post to learn the types and contexts of real vs. fake breakouts. See Part III of this post for advice on how to trade breakouts.