On Trading Breakouts: Real vs. Fake Breakouts

Books on trading generally tell you to just go ahead and buy or sell a breakout. They don’t give any guidance on false breakouts—why they happen or how to protect yourself from them, and they don’t tell you how to trade a breakout to maximize your chance of success and avoid stop-outs.

So here are some rules of thumb for understanding the causes of real versus fake breakouts and distinguishing between them.

Rule of Thumb #1: Many Trading Formations Complete with a False Breakout Due to Market Psychology

Trading formations like triangles, rising and falling wedges, and megaphones can only complete with either a false breakout (that leads to a price reversal) or a price move that fizzles out somewhere in the middle of the formation. It works the same way with price moves that have oscillated neatly up price channels—the move never ends precisely on a price channel side.

So you have to understand from the start when trading breakouts that a breakout can signal the end of a move as often as the beginning of a move.

The reason is simple. Trading formations or channeled price moves involve price turns on an exact line. That line tends to be created by market makers and then maintained by other highly informed market participants. When everyone tacitly agrees to trade within a set of lines, that agreement tends to carry on until you either run out of one type of participant (buyers or sellers) or some kind of big news suddenly shifts market sentiment or brings new, less well-informed traders surging into a market.

In other words, price channels or trading ranges or trading formations end because of passion or indifference. Passion means a breakout; indifference means a fizzle out. It’s not in the nature of passion or indifference to start and stop on exact lines.

Again, passion can be due to new information that can carry the price a long way. That’s the type of breakout you want to bet.

But passion can also mean capitulation and the climax of a move. That’s the kind of fake breakout that completes a formation and leads to a price move in the opposite direction.

Rule of Thumb #2: Fake Breakouts Are Also Deliberately Created by Big Money Traders Specifically So They Can Unload Inventory

After long price moves, market participation can get very thin. (In other words, volume goes down.) It can be very difficult in such a situation for big money like hedge funds or big bank trading desks to unload huge unwanted positions without causing the price to go down and erase a lot of their profits.

What they will often do in such a situation is nudge the price through an important barrier to attract technical traders who trade breakouts. A significant breakout, like a new high, or an upward breakout from a triangle or long consolidation, attracts volume buying that the big money can sell into without taking down the price.

Head and shoulders formations are a classic topping pattern that demonstrates this principle. Big money starts to sell. The price starts to fall hard. Rather than chase the price down, big money stops selling and lets the price recover back up to near the high. Big money may then actually buy to nudge the price to a new high and attract breakout buyers. Big money then sells into the new heavy buying until the selling overwhelms the buying and the price goes down into the dip before the right shoulder.

This same principle is also often at work in fake triangle or wedge breakouts.

When to Trade a Breakout

At the end of a long price move, a sudden surge in volume with a huge move in price (very long price candles) often signals capitulation. If the price move was upwards, sellers simply stop trying until the bulls burn themselves out. If the price move was downwards, the dip buyers give up and the price goes into a climactic crash.

This type of breakout is real, but tends to signal the end of a price move. Avoid buying or selling in the direction of this type of climactic breakout. Instead, look for a signal to enter a trade in the opposite direction.

The kind of breakout you want to trade is a genuine breakout from some kind of consolidation or trading formation, like a triangle or rising wedge or head and shoulders formation. Consolidations represent a temporary agreement on price. A  genuine breakout from a consolidation represents a significant change in a market and will often lead to a large price move without the kind of early volatility that can stop you out.

Breakouts from topping or bottoming patterns can also be excellent bets, even when the formation has a price direction, like a rising wedge. The key is to look for breakouts that represent a change in sentiment, or the overcoming of one force by another force.

One signal of a genuine breakout can be a fake breakout on the other side of the consolidation or trading formation. If the price breaks out the bottom of a triangle but quickly stops and reverses direction, then goes up and breaks out the top, the odds are increased that the upward breakout is genuine.

But the best way to tell if a breakout is genuine or fake is to watch the price action. Part II of this article provides a detailed description of the differences in the price action in real and fake breakouts, with an explanation of the underlying cause of these differences.

Part III of this article goes into detail on how to actually trade breakouts to maximize your chances of success.