While trading, it's common to find false breakouts in any time frame. But did you know that you can actually take advantage of these so-called failed breakouts?
There are many paths to take if you want to earn profits in forex trading. Having a good trading strategy is extremely important to manage your position in the market and works as the base for your trading actions. But even so, getting profits and minimizing risks are still not easy to achieve in forex trading.
Some traders like to follow the market's trend and use the breakout strategy to determine their entry points. These trend followers can watch and observe the market for hours, days, even weeks and months to make sure that their positions are still profitable.
However, the forex market is highly volatile, so there are lots of price movements that can happen at any time and might not go the way they planned. The breakout strategy may fail, and instead of giving them a strong trend continuation, the price ends up changing direction almost immediately.
This is what we call a "false breakout" and it often happens in forex trading. It does sound bad, but what if we can take advantage of those "mistakes" instead? Here's a complete guide to breakout strategy and how to take advantage of false breakouts.
What is a Breakout?
The term "breakout" basically refers to any price movement that breaks through any defined key levels, whether they are high and low levels, support and resistance, supply and demand, or even psychological levels. The breakout can occur either horizontally or diagonally, depending on the price action pattern. Once the price breaks through a barrier, volatility tends to increase and the price usually continues going in the breakout's direction. Therefore, this is an excellent time for traders to enter the market and take advantage of the trend after a breakout.
You are free to choose between intraday, daily, or weekly charts to project this strategy. Also, compared to the typical trend following methods which rely on signals at the end of temporary corrections, the breakout strategy has a more promising opportunity because it is usually driven by market psychology and the continuation tends to last longer.
Trading with Breakout Strategy
When using the breakout technique during a downtrend, first determine the support level, then the current lowest level (Low). If the downtrend is strong, then the price will definitely form a new low so that the trend can continue. The most effective way to determine the entry point in this situation is to use a pending order. In this case, the entry level should be placed below the current low.
Meanwhile, during an uptrend, first look for the resistance level and the current highest point (high). Then use the pending order and place an order above the recent high.
It is also highly crucial to confirm the breakout. Sometimes, traders would simply see if the price breaks through the barrier and immediately decide that it is a breakout. But in reality, the market doesn't always respond the way we think. The price could move back and forth because the big players would take advantage of impatient traders rushing to enter around a breakout. Thus, always make sure to confirm the breakout before deciding to buy or sell.
There are three simple conditions to confirm a breakout:
- Determine the key support and resistance levels. Make sure that the price breaks through one of them.
- Make sure that the closing price of the breakout candlestick bar is above the key resistance level or below the key support level. The further it is from the key level, the more valid the signal.
- Wait for a few more bars to form just in case the price might change direction again. Make sure that the price is really entering a new high or low after the breakout. If you use a daily time frame, the waiting time is usually 3 days or 3 bars. If you use an even lower time frame, it can take up more than 3 bars to confirm the breakout.
Understanding False Breakout
We have mentioned that confirming the breakout is highly important in this strategy. Sometimes, the price will break the barrier for a little while only to come back in the opposite direction. This is called a false breakout.
There are several reasons why the market failed to break out. Commonly, it is caused by the tough battle between the big players such as the central banks, financial institutions, and hedge fund managers.
See Also: The Creators of Market Trend
If one of them does not wish the price to pass a certain level, it will immediately double its lot size and increase its position. In times like this, the other players can also go with the flow and follow the path by making orders in the opposite direction. As a result, the price will slide quickly and sharply turn in the opposite direction from the breakout.
How to Avoid False Breakouts
Apart from confirming the breakout before entering the trade, there are several other ways to avoid false breakouts:
- Look at a higher time frame. This way, it's easier to confirm the validity of the breakout because there's more information available on the chart.
- Confirm with price action. You can use your technical analysis skill on this one because it's important to pay attention to what candlestick patterns are formed at the key levels that the price is trying to break. If the candlestick forms a reversal pattern such as Pin Bar, Doji, Engulfing, or Three Inside, then you should be prepared for a reversing movement.
- Use additional indicators. You can anticipate a false breakout by using indicators like Oscillators (RSI, Stochastic, CCI, MACD, etc.) and ADX. The key is simple: if the trend's momentum is increasing, then there's a big chance of a breakout. But if the momentum is weakening, then the breakout may be false.
Using False Breakouts to Your Advantage
What's interesting about false breakouts is that apart from the fact that they can ruin your breakout strategy, you can actually use them to your advantage instead. This is often called the way of contrarian trading.
Like breakouts, false breakouts can happen in any time frame and market condition. Here's an example of false breakouts on a sideway or ranging market.
From the chart, we can see that there are 4 false breakouts; 3 occur at the resistance level while the other 1 occurs at the support level. Traders who are familiar with price action analysis are surely able to identify the false breakout by looking at the candlestick patterns.
The first circle identifies a strong bullish candle followed by a similarly strong bearish candle, indicating a strong market consolidation. We can go long only when the highest level of the bullish candle has been broken. But alas, the price never rises past the bullish candle's high and goes back down as shown in the chart above. Typically, contrarian traders will use limit orders in areas close to resistance or support levels (in this case, sell limits in 1, 3, 4 and a buy limit in 2).
To know for sure which strategy works best, we should understand the overall price movement by referring to a higher time frame so we can see the dominant trend at that time. If the uptrend is dominant, the sideway chart will tend to break the resistance. But if the downtrend is the predominant one, the chart will tend to break the support level.
The forex market is a really volatile place. One of the worst things that can happen to a forex trader is getting caught in the middle of the wave, where the market moves back and forth in an unpredictable, extreme manner. Breakout strategy can be really profitable for any trader, but there are times where your prediction may not work out and you could end up losing a lot of money.
That is why false breakout is a great backup strategy that can offer a way to make back the money that you may have lost on the traditional breakout trade. However, trading with a false breakout strategy is not exactly easy for beginners, so it would be a big help to learn certain things like technical analysis and price action before you use it.