The price finally breaks through that resistance level you’ve been watching like a hawk. You feel the rush, click buy – and then the price crashes right back down. False breakouts are a trader’s worst nightmare – and I’m sure you’ve been there before more times than you care to admit. It’s infuriating.
Let’s face it, learning how to spot a false breakout can be the difference between making a profit and losing your shirt. Seasoned traders know all about these little traps, how to spot a genuine breakout, and use all sorts of advanced techniques and technical indicators to weed out the fakes.
By the time you finish reading this guide, you’ll know exactly how to spot those fake-outs, trade without getting too hasty, and keep your hard-earned cash safe.
What the heck is a false breakout anyway?
Think back to a time when you were playing basketball. The player makes a fake move – they fake a pass to one side and then quickly whip it to the other. The market does the same thing to us traders. Side note: I suck at Basketball.
A true breakout happens when a price pushes through a key support or resistance level and just keeps on going. In technical speak, a support level (or key support) is a price point where the market tends to find buyers and start moving higher. A resistance level, on the other hand, is where selling interest is strong, and prices tend to fall.
A false breakout in day trading is when a stock’s price suddenly surges through a key support or resistance level, but then fails to keep moving, quickly dropping back into its old trading range.
It’s a trap that catches all the impatient traders off guard – folks who jump into a trade the moment the price line is broken.
Candlesticks on false breakouts will often have long wicks, showing a big swing in price that fails to stick. And the worst part is, this happens in all sorts of markets – stocks, forex, and cryptocurrency. The psychology behind it is always the same.
Smart traders use false breakouts to their advantage – they trade in the opposite direction, capitalizing on the panic of the trapped buyers.
Don’t get caught up in the hype – think about market conditions
Before you even think about trading breakouts, take a step back and think about the bigger picture. That’s where most traders go wrong – they’re so focused on the breakout itself, they forget to look at the overall market conditions.
False breakouts are more common when the market is stuck in a range, just bouncing back and forth between support and resistance. If you’re trading in these conditions, be super cautious.
Start by identifying the overall trend – if there is one. Look at your moving averages and see if the market is trending up or stuck in a rut. If the moving averages are just flat and price keeps coming back to the same levels, you’re likely in a range. In these situations, breakouts are more likely to fail, so your trading strategy needs to be a lot more conservative.
Don’t fall for these rookie mistakes
Don’t go into a trade without checking for upcoming economic news or events that could shake the market up.
A sudden spike in volatility can trigger a false breakout, especially if there’s not much buying or selling going on.
Tools like the Relative Strength Index (RSI) and Bollinger Bands can help you spot when a stock is overbought or oversold, giving you a hint about whether a breakout is going to stick.
By taking the time to think about the bigger picture, you’ll be able to spot when a breakout is probably a false alarm – and when it’s just another trap waiting to spring.
This is one of the key differences between winning and losing traders.
How to avoid getting burned
You need to have a solid plan in place to weed out the bad trades. Here are a few simple ways to avoid getting faked out. Common mistakes traders make include rushing into a trade too quickly and not waiting for confirmation, which often leads to getting caught out in a false breakout and missing out on key warning signs.
To avoid falling for these traps, you need to be patient and disciplined in your approach.
To avoid getting sucked in by a false breakout, just wait for confirmation – like a candle closing outside the range or a retest of the breakout level – before you even think about entering a trade. Many traders fail to wait for this confirmation, which means they end up losing money unnecessarily.
Be patient and don’t get caught out by the Pin Bar
Patience is your best friend in day trading. Novice traders make the mistake of jumping into a trade the second a price line is broken.
Instead of acting on emotion, just wait. Let the candlestick fully close. If the price tries to break through a level but fails to close above it, that’s a warning sign.
If a five-minute candle pushes past resistance but closes back below it, that’s a massive warning sign.
It shows that the buyers were trying to push the price up, but the sellers took over straight away.
If the breakout candle fails to close decisively beyond the support or resistance level, the breakout is likely a dud.
A good breakout needs a strong candle closing outside the range.
Don’t get tunnel vision, keep an eye on the big picture
Using a multiple time frame analysis approach helps you get a clearer view of things by looking at different time frames, like daily charts.
Taking a second to take a glance at the hourly or daily chart while trading on a five-minute chart can really help you out.
A breakout on a short timeframe might be nothing more than just normal market noise on a longer timeframe. When you zoom out, you get some much-needed context to make a smart decision.
It’s also worth noting that breakouts that occur against the dominant higher-timeframe trend have a pretty high failure rate. Using multiple time frame analysis lets you spot false breakouts by looking at price action across different periods.
Checking the Engine’s Momentum
When the price is heading towards a key level, take a close look at your momentum indicators like the RSI or your overall volume.
Checking out the volume during a breakout will give you a heads up of a warning sign of a potential false breakout – a true breakout is characterised by strong volume and aggressive buying or selling, while a false breakout often occurs with weak volume.
- Divergence in momentum – when the price moves to a new high but indicators like RSI or MACD show lower highs – can be a signal that momentum is waning and a false breakout is on the cards.
- Pin bars and bearish pin bars are candlestick patterns that can signal potential reversals or false breakouts, especially around support and resistance levels.
- Also, indicators like RSI divergence and overextended moves can signal potential false breakouts when the price returns inside the trading range.
- A tight, quiet range is always low volatility, usually means the market is building up energy.
If the price breaks out with a massive surge in volume and increasing momentum, it really has the juice to keep going. If the volume is low, it’s probably just setting a trap.
Risk Management – Protecting Your Account from False Breakouts
No matter how good you get at spotting false breakouts, some are still going to slip through the net. That’s why risk management is your safety net. Top traders know that protecting your account is just as important as finding the perfect trade.
Start by always using a stop-loss order. It’s a simple tool that limits your downside if the market suddenly reverses after a breakout.
Set it just beyond the broken level – close enough to protect you, but not so tight that normal price action knocks you out.
Keep your position size under control. It’s tempting to bet big when you think you’ve got a real breakout, but false breakouts will wipe out your account if you’re overexposed. Use a consistent position size that fits your risk tolerance and trading style.
By making risk management a core part of your trading strategy, you’ll be able to ride out the inevitable false breakouts and keep your account healthy for the long haul.
Keep Moving Forward
Trading is a journey of continuous learning – every mistake is just a lesson in disguise. Now that you know how to spot false breakouts, you can approach the market with a bit more confidence. Start by reviewing your past trades. Did you jump in before a candle closed? Did you forget to check the higher timeframe?
Take some time to review your trade setups and fine-tune your approach. I review my trades after every trading day. It sucks, but it needs to be done.
This is one of the many frustrating obstacles you’ll encounter on this path. But don’t let it get you down – just push through it and keep moving. As long as you don’t give up, you’ll make it round the corner.
