Here are two clear examples of false breakouts above and below key levels.
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Note that false breakouts can take different forms. Sometimes a false break will occur with a pin bar pattern or a fakey pattern as the false break, and sometime not:. Professional traders watch for these missteps by the amateurs, and the end result is a very good entry for them with a tight stop loss and huge risk reward potential. The important thing, is to know what they look like and how to trade them, which we will discuss next….
False breaks occur in all market conditions; trending, consolidating, counter-trend, but perhaps the best way to trade them is in-line with a dominant daily chart trend, like we see in the chart below. Note, in the chart below, we had a clear downtrend in place and multiple false breakouts to the upside within that trend. Amateur traders love to try and pick the bottom in a downtrend or the top in an uptrend, and this can cause false breakouts against the trend like we see below.
On each of these false-breaks in the chart below, it was likely that amateur traders thought the downtrend was over and so they started buying, once this buying started the professionals came back in and took advantage of the temporary strength within the down-trending market and entered short from value, and then the downtrend resumed, flushing out all those amateur traders who tried picking the bottom.
The chart below shows examples of false breakouts within a down-trending market. Note that each one led to a resumption of the trend…. False-breaks are prevalent in trading ranges because traders often try to pick the breakout of the range but usually price stays range-bound for longer than most assume.
Knowing that false-breaks are somewhat common when a market is struck in a trading range is a very valuable piece of information for a price action trader. Trading a range-bound market can be very lucrative as you can wait for price action signals at the support or resistance boundary of the range to trade back toward the other side of the range. In the chart below, we can see how a price action trader can use a false breakout pin bar signal to trade a false breakout of a trading range.
The two false-breaks of support in the chart below were both potential buy signals for a savvy price action trader….
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- When and why false breakouts occur.
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False breakout patterns can sometimes signal the beginning of a new trend, and the end of the current one. The pair goes on to close the day back above your key level, negating the entire trade idea as well as your bearish bias. Sure it does. Even the best looking trade setups can and do fail on occasion.
Better yet, how could you have mitigated the risk or perhaps even benefited from the false break itself? By the time you finish reading this lesson, you will have a firm understanding of what false breaks are, why they form as well as how to take advantage of them. First things first, before you can learn how to use false breakouts to your advantage, you have to know what they are and how to identify them. A false break, or breakout, as the name implies, is any move and subsequent close above or below resistance or support respectively followed by a reversal that fails to respect the broken level as new support or resistance.
Notice how NZDJPY closed above channel resistance on a 4-hour basis but subsequently failed to hold above it as new support. If a currency pair merely pierces a critical level, it is not considered a false move. For example, I see a lot of traders incorrectly labeling the two instances below as false breaks. This brings us to the next, very important subject of time frames.
RSI: a value judgement
The time frame you use to trade and thus identify these false breakouts is paramount to the overall effectiveness of this strategy. The two instances above were clearly NOT false breaks on the daily chart as well as any time frame above the daily. As you can see, while the daily chart never closed above resistance, the 4-hour chart certainly did. Perhaps, but remember that one of the ingredients for any false break is an obvious level of support or resistance.
The retest in the chart above occurred after just one other test of resistance. With this in mind, attempting to trade or even analyze the price action on a 4-hour closing basis would be ill-advised. To understand why we have to go back to price action trading One of the tenants of trading between support and resistance is that you must know which time frame is respecting a given level or pattern.
In the case of the EURGBP chart above, the 4-hour had not established itself as the predominant period in relation to the resistance level. In this case, the 4-hour chart was clearly respecting the pattern and could therefore be used to assess the implications of the false break that eventually materialized.
In my experience, the 4-hour and daily periods work the best. However, each situation is unique, so it all depends on which time frame is respecting the key level in question. Just like the pin bars we use when trading price action, a breakout that immediately fails is a sign of strength or weakness. We can use this to our advantage just like any other price action signal.
Contrarian Method for Trading False Reversals
The same applies to any combination of time frames. Once the pair closed back below the upper boundary of the structure, it was time to begin watching for selling opportunities. In summary, we would have looked to sell on a 4-hour close back below resistance with a target at channel support.
Remember how I mentioned that you could have mitigated the risk of getting sucked into these traps at the beginning of this lesson? The best way to do that is through a firm understanding of price action.
And that involves more than just pin bars and inside bars. The pattern in question is an ascending channel and therefore has bearish implications.
How To Trade False Breakouts The Right Way (Or Avoid Them)
As such, we would only want to trade a breakout below channel support, which never materialized before the close above resistance. Technically speaking, the pattern above was a bearish flag as it was the result of an impulsive move lower. That meant that any buying was counter-trend and thus not advisable. Pro Tip: As a general rule, ascending patterns have bearish implications while descending patterns have bullish implications. But through the combined use of technical patterns and bullish or bearish price action, you can give yourself the edge needed to make money over an extended period.
The false breakout strategy discussed above is ideal for the more advanced price action trader. Remember that like any trading strategy, technique or concept, the ideas discussed in this post are based on probabilities, not guarantees. So while a false break of a given level can often result in an extended move in the opposite direction, it does not guarantee the outcome as such. Whether you use these teachings to formulate an outright trading strategy or only use them to assist in your technical analysis is up to you.
As for me, I simply use the technique above as a way to gauge market strength and therefore add conviction to an already established trade idea. Save my name, email, and website in this browser for the next time I comment.
Simple Way to Avoid False Breakouts
Hi, nice article, thank you. I am trading FX with trendlines for the passed 8 years. This was a profitable trade for us due to the strategy mentioned above. You may be referring to drawing the resistance level a bit higher, which could also be true. But as I pointed out above, the bullish pin bar that formed on the 4-hour chart confirmed that the resistance level was positioned correctly.