Summary: Trading Breakouts and Fakeouts

Trading Breakouts

With breakout trades, the goal is to enter the market right when the price makes a breakout and then continue to ride the trade until volatility dies down.

Breakouts are significant because they indicate a change in the supply and demand of the currency pair you are trading.

You'll notice that unlike trading stocks or futures, there is no way for you to see the volume of trades made in the forex. Because of this, we need to rely on volatility.

Volatility measures the overall price fluctuations over a certain time and this information can be used to detect potential breakouts.

There are a few indicators that can help you gauge a pair's current volatility. Using these indicators can help you tremendously when looking for breakout opportunities.

·         Moving Averages

·         Bollinger Bands

·         Average True Range (ATR)

There are two types of breakouts:

·         Continuation

·         Reversal

To spot breakouts, you can look at:

·         Chart Patterns

·         Trend lines

·         Channels

·         Triangles

You can measure the strength of a breakout using the following:

·         Moving Average Convergence/Divergence (MACD)

·         RSI

Finally, breakouts usually work best and FOR REAL with some kind of economic event or news catalyst. Always be sure to check the forex calendar and news before figuring out whether or not a breakout trade is the right play for the situation.

Trading Fakeouts

Institutional traders like to fade breakouts. So we must like to fade breakouts also. 
Are you going to follow the crowd, or are you going to follow the money?

Think, act, eat, sleep, and watch the same movies as these guys do. If we can trade in the same way the institutional players do, success is just a glimpse away.

Fading breakouts simply means trading in the opposite direction as the breakout. You would fade a breakout if you believe that a breakout from a support or resistance level is false and unable to keep moving in the same direction.

In cases in which the support or resistance level broken is significant, fading breakouts may prove to be smarter than trading the breakout.

Potential fake outs are usually found at support and resistance levels created through trend lines, chart patterns, or previous daily highs or lows.

The best results tend to occur in a range-bound market. However, you cannot ignore market sentiment, common sense, and other types of market analysis.

Financial markets spend a lot time bouncing back and forth between a range of prices and do not deviate much from these highs and lows.

Finally, the odds of a fake out are higher when there is no major economic event or news catalyst to shift traders' sentiment in the direction of the break.

How to Trade Fakeouts

In order to fade breakouts, you need to know where potential fake outs can occur.

Potential fake outs are usually found at support and resistance levels created through trend lines, chart patterns, or previous daily highs or lows.

Trend lines

In fading breakouts, always remember that there should be SPACE between the trend line and price.

If there is a gap between the trend line and price, it means price is heading more in the direction of the trend and away from the trend line. Like in the example below, having space between the trend line and price allows price to retrace back towards the trend line, perhaps even breaking it, and provide fading opportunities.

The SPEED of price movement is also very important.

If price is inching like a caterpillar towards the trend line, a false breakout may be likely. However, a fast price movement towards the trend line could prove to be a successful breakout. With a high price movement speed, momentum can carry price past the trend line and beyond. In this situation, it is better to step back from fading the breakout.

How do we fade trend line breaks?

It's very simple actually. Just enter when price pops back inside.

This will allow you to take the safe route and avoid jumping the gun. You don't want sell above or below a trend line only to find out later that the breakout was real!

Using the first chart example, let's point out possible entry points by zooming in a little.

Chart Patterns

Chart patterns are physical groupings of price you can actually see with your own eyes. They are an important part of technical analysis and also help you in your decision-making process.

Two common patterns where false breakouts tend to occur are:

·         Head and Shoulders

·         Double Top/Bottom

The head and shoulders chart pattern is actually one of the hardest patterns for new traders to spot. However, with time and experience, this pattern can become an instrumental part of your trading arsenal.

The head and shoulders pattern is considered a reversal. If formed at the end of an uptrend, it could signal a bearish reversal. Conversely, if it is formed the end of a downtrend, it could signal a bullish reversal. Head and shoulders are known for generating false breakouts and creating perfect opportunities for fading breakouts.

False breakouts are common with this pattern because many traders who have noticed this formation usually put their stop loss very near the neckline.

When the pattern experiences a false breakout, prices will usually rebound. Traders who have sold the downside breakout or who have bought the upside breakout will have their stops triggered when prices move against their positions. This usually is caused by the institutional traders who want to scrape money from the hands of individual traders.

In a head and shoulders pattern, you can assume that the first break tends to be false.

You can fade the breakout with a limit order back in the neckline and just put your stop above the high of the fake out candle.

You could place your target a little below the high of the second shoulder or a little above the low of the second shoulder of the inverse pattern.

The next pattern is the double top or the double bottom.

Traders just love these patterns! Why you ask? Well it is because they're the easiest to spot!

When price breaks below the neckline, it signals a possible trend reversal. Because of this, plenty of traders place their entry orders very near the neckline in case of a reversal.

The problem with these chart patterns is that countless traders know them and place orders at similar positions. This leaves the institutional traders open to scrape money from the commoner's hands.

Similar to the head and shoulders pattern, you can place your order once price goes back in to catch the bounce. You can set your stops just beyond the fake out candle.

What kind of market should I fade breakouts?

The best results tend to occur in a range-bound market. However, you cannot ignore market sentiment, major news events, common sense, and other types of market analysis.

Financial markets spend a lot time bouncing back and forth between a range of prices and do not deviate much from these highs and lows.

Ranges are bound by a support level and a resistance level, and buyers and sellers continually push prices up and down within those levels. Fading the breakouts in these range-bound environments can prove to be very profitable. However at some point, one side is eventually going to take over and a new trending stage will form.

Fade the Breakout

Fade the breakout you say? Was that just a typo? Did you mean to say, "trade the breakout"?

Nope!

Fading breakouts simply means trading in the opposite direction of the breakout.

Fading breakouts = trading false breakouts.

You would fade a breakout if you believe that a breakout from a support or resistance level is false and unable to keep moving in the same direction. In cases in which the support or resistance level broken is significant, fading breakouts may prove to be smarter than trading the breakout.

Keep in mind that fading breakouts is a great short-term strategy. Breakouts tend to fail at the first few attempts but may succeed eventually.

REPEAT: Fading breakouts is a great short-term strategy. It is not a great one to use for longer term traders. By learning trade false breakouts, also known as fakeouts, you can avoid getting whipsawed.

Trading breakouts appeal to many independent traders. Why?

Support and resistance levels are supposed to be price floors and ceilings. If these levels are broken, one would expect for price to continue in the same direction as the breakage.

If a support level is broken, that means that the general price movement is downwards and people are more likely to sell than buy.

Conversely, if a resistance level is broken, then the crowd believes that price is more likely to rally even higher and will tend to buy rather than sell.

Independent retail traders have greedy mentalities. They believe in trading in the direction of the breakout. They believe in huge gains on huge moves. Catch the big fish, forget the small fries.

In a perfect world, this would be true. But the world is not perfect. Frogs and princesses do not live happily ever after. What does in fact happen is that most breakouts FAIL.

Breakouts fail simply because the smart minority has to make money off the majority. Don't feel so bad. The smart minority tends to be comprised of the big players with huge accounts and buy/sell orders.

In order to sell something, there must be a buyer. However, if everyone wants to buy above a resistance level or sell below a support level, the market maker has to take the other side of the equation. And let us warn you: the market maker ain't any fool.

Retail traders like to trade breakouts.

The smart minority, the institutional, more seasoned traders, prefer to fade breakouts.

The smarter traders take advantage of the collective thinking of the crowd or inexperienced traders and win at their expense. That is why trading alongside the more experienced traders could be very profitable as well.

Which would you rather be part of: the smart minority that fades breakouts or the losing majority that gets caught in false breakouts?

Trading Fakeouts

Breakouts are popular among traders.

It makes sense right?

When price finally "breaks" out of that support or resistance level, one would expect price to keep moving in the same direction of the break. There must have been enough momentum building up in order for price to have broken out of the level, right?

It's time to hop aboard that train. It's all smooth sailing now. All you have to do is just wait for it...

Yes, wait for it...

Wait for it... Just a few more moments... To see price inch one direction... Then suddenly move miles in the opposite direction!

Huh?!? What the heck?! What happened to "the bread and butter and the end of world hunger" strategy?

End of story: You are left eating ketchup packets and crackers like Tom Hanks in The Terminal.

One thing you should remember to note about support and resistance levels is that they are areas in which a predictable price response can be expected.

Support levels are areas where buying pressure is just enough to overcome selling pressure and halt or reverse a downtrend.

A strong support level is more likely to hold up even if price breaks the support level and it provides traders a good buying opportunity.

Resistance levels are just like support levels but work in the opposite way. They tend to halt or even reverse uptrends.

Resistance levels are areas in which selling pressure is just enough to overcome buying pressure and force price back down.

Strong resistance levels are more like to hold up even if price breaks the resistance level and it provides traders a good selling opportunity.

In the next section, we will dive deeper into fakeouts and discuss why we should trade them and how to profit off them.

It's not enough learning about breakout strategies because there will be times that breakouts fail. We have to know what to do in case of fake outs.

This is part of your Jedi forex training. To be a Jedi master, you must be able to master fakeouts.

Measuring the Strength of the Breakout

            As you learned earlier, when a trend moves for an extended period of time and it starts to consolidate, one of two things could happen:

1.    The price could continue in the same direction (continuation breakout)

2.    The price could reverse in the opposite direction (reversal breakout)

Wouldn't it be nice if there was a way to know to confirm a breakout? If only there was a way to avoid fake outs...

Hmmm...

You guessed it.... THERE IS A WAY!

In fact, there are a couple of ways to tell whether or not a trend seems to be nearing its demise and a reversal breakout is in order.

Moving Average Convergence/Divergence (MACD)

By now you should have a good foundation of the MACD indicator. If you don't, you might want to check out our lesson on MACD.

MACD is one of the most common indicators used by traders and for good reason. It is simple yet dependable and can help you find momentum, and in this case, the lack of momentum!

MACD can be displayed in several ways but one of the "sexiest" ways is to look at it as a histogram. What this histogram does is actually show the difference between the slow and fast MACD line. When the histogram gets bigger, it means momentum is getting stronger. When the histogram gets smaller, it means momentum is getting weaker.

So how can we use this when trying to spot a trend reversal? Glad you asked!

Remember that trading signal we talked about earlier called divergences and how it occurs when the price and indicators move in the opposite direction? Since MACD shows us momentum it would make sense that momentum would increase as the market makes a trend. However, if MACD begins to decrease even when the trend is continuing, you can deduce that momentum is decreasing and this trend could be close to an end.

You can see from the picture that as price was moving higher, MACD was getting smaller. This meant that even as the price was still trending, momentum was beginning to fade out. From this information, we can conclude that a trend reversal is highly likely.

Relative Strength Index (RSI)

RSI is another momentum indicator that is useful for confirming reversal breakouts. Basically this indicator tells us the changes between higher and lower closing prices for a given period of time. We won't go into too much detail about it but if you would like to know more check out our lesson on RSI.

RSI can be used in a similar way to MACD in that it also produces divergences. By spotting these divergences, you can find possible trend reversals.

However, RSI is also good for seeing how long a trend has been overbought of oversold. A common indication of whether a market is overbought is if the RSI is above 70. On the flipside, a common indication of whether a market is oversold is if the RSI is below 30.

Because trends are movements in the same direction for an extended period of time, you will often see RSI move into overbought/oversold territory, depending on the direction of the trend.

If a trend has produced oversold or overbought readings for an extended period of time and begins to move back within the range of the RSI, it is a good indication that the trend may be reversing.

In the same example as before, the RSI showed that the market was overbought for a billion days (ok not that long). Once RSI moved back below 70, it was good indication that the trend was about to reverse.