Trading Breakouts and Fakeouts in Depth Overview

What Are Breakouts in Trading?

A breakout signifies the instance when the value of a currency moves beyond a predefined level of support or resistance, accompanied by an upsurge in the volume of trades.

Traders who specialize in breakouts opt for a long position once the currency’s price exceeds the resistance level or a short position when it drops below the support level. Once the stock price surpasses the price barrier, the level of volatility tends to spike, and prices usually follow the same trend as that of the breakout. The reason why breakouts are such a crucial element in trading strategies is that they serve as the starting point for future upswings in volatility, significant price swings, and, in many cases, substantial price trends.

Breakout Indicators

The indicators that traders utilize for breakout trading include the MACD, RSI, volume indicator, and all types of oscillator indicators. By drawing a trendline on an oscillator indicator line, traders can predict the occurrence of a breakout when the price level breaches the trendline.

Among these indicators, the RSI (Relative Strength Index) is considered the most reliable for confirming a breakout. Traders can draw trendlines on RSI to determine the precise position for support, resistance, or trendline breakout. This method provides the most accurate prediction of the potential breakout position.

Breakout Patterns

Breakouts are frequently linked with chart patterns, such as ranges, triangles, flags, wedges, and head-and-shoulders. These patterns manifest when the price moves in a particular way, resulting in clearly defined support and/or resistance levels. Traders then observe these levels for signs of a breakout. If the price surpasses the resistance level, traders may initiate long positions or exit short positions. Conversely, if the price drops below the support level, traders may initiate short positions or exit long positions.

Types of Breakouts Trading

There are two main types of trading breakouts in the forex market. They can be stated as

• Continuation breakouts
• Reversal breakouts

Understanding the type of breakout will help you understand the big picture of the market and actually where it is heading.

Continuation Breakouts

Usually, the market takes a break after it records an extensive movement in one single direction. This happens when traders pause to understand what should be their next step. This results in a period of limited movement, which we call as consolidation.

When traders decide that the trade they are in is right and expect to stay in the same trade that pushes price further in the same direction, then the outcome is a continuation breakout.

Reversal Breakouts

Reversal breakouts mark their start in the same way as that of continuation breakout. They look for the consolidation phase.

However, the only difference this time is that they realize the trend is over and push the price in reverse direction. This approach leads in a reversal breakout.

False Breakouts

Now, when the traders are aware that something like breakouts exists in the market, then they should trade with extra caution. There is always a chance that the market can produce false breakouts, which may force you to be on the wrong side of the trade. False breakouts are noted when the price moves past a certain level but fails to move in that direction.

Breakout Trading Strategy

The objective of breakout trades is to enter the market immediately after the price experiences a breakout and then sustain the trade until the volatility subsides. So, you should focus on volatility and use it for your advantage.

Hence, let’s understand the volatility.

What is Volatility?

Volatility is the term used to describe changes in asset prices. It is calculated by determining the variance between the opening and closing prices within a specific time frame.

How to Measure Volatility?

You can use volatility when identifying good breakout trade prospects. It helps you to know the overall price fluctuations in a given period and then identify potential breakouts. Few indicators can help you understand a pair’s current volatility. These indicators are:

 

• Moving Average
• Bollinger Bands
• Average True Range

Moving Average

Moving averages are one of the most prevalent indicators used by forex traders. It is a simple way to get invaluable information for making informed trade decisions. Moving averages compute the average movement of the market in a given period (say X) of time. Let say, you apply 20 simple moving average to a daily chart. This SMA will give you the average price movement in the last 20 days.

In addition to simple moving averages, you can also use weighted moving averages and exponential moving averages.

Bollinger Bands

Bollinger bands form another best tool for knowing volatility. They are two lines that are sketched two standard deviations below and above a moving average for an X amount of time, as defined. For example, if X is set at 20, then there will be 20 SMA and two other lines. You will find one line set -2 standard deviations below it, and the other plotted +2 standard deviations above. The volatility is high when the bands widen, and it is low when they contract.

Average True Range (ATR)

Average True Range marks as a vital tool for knowing volatility. Using ATR, you can know about the average trading range for X period. If ATR is set as 20 on a daily chart, you can get the average trading band for the past 20 days. A falling ATR is an indication of declining volatility.

Trade Breakouts Using Triangles, Trend Lines and Channels

You can always identify the breakouts in the forex market with ease. Once you start understanding the signs of breakout on the chart, you can always enter into trades at the right time. Some of the most used chart patterns for knowing the breakouts are as under:

• Double Top/Bottom
• Head and Shoulders
• Triple Top/Bottom

Besides chart patterns, there are many other indicators and tools that you can apply to identify a reversal breakout.

Trend Lines

The first way to identify a possible reversal breakout is by using trend lines. Look at the chart, and then sketch a line that moves with the ongoing trend.

Connect at least two bottoms or tops. You can even connect more as it will support your trend line more rationally. Now, when the price moves closer to the trend line, two things can happen:

The price could breach the trend line and support the trend.

The price can face resistance at the trend line and witness a reversal.

However, just looking at the price level may not help. You have to use along with another technical indicator, which we call as MACD. You can see it in the example given below. When the EUR/USD pair broke the trend line, the MACD indicator was indicating bearish momentum.

Channels

Another way to identify breakout opportunities is by using trend channels. You can draw trend channels in the same way as you draw trend lines. However, the only difference is that post you sketch a trend line you will be required to add one more at the other side. Channels help you know both bearish as well as bullish breakouts. In the below example, the MACD was indicating bearish momentum that again supported the breakdown of the EUR/USD pair below the lower line of the channel.

Triangles

Triangles are noted when the price starts to consolidate into a range after witnessing significant volatility. There are three types of triangles:

• Ascending triangle
• Descending triangle
• Symmetrical triangle

Method To Know the Strength of a Breakout

When prices consolidate after trending in one direction for an extended period, either of two types of breakouts could be noted:

• Continuation breakout – The price will continue to trend in the same direction.
• Reversal breakout – The price will start trading in the opposite direction.

There are ways to understand whether a breakout is a continuation breakout or a reversal breakout. Two of these ways are explained below.

Moving Average Convergence/Divergence

Popularly called as MACD, it is one of the most prevalent indicators applied by forex traders. It is a simple way that can help you know the lack of momentum in the case of breakouts.  MACD can be shown in many ways, but one of the best ways is to see at it as a histogram. In this way, you are in a position to understand the difference between the fast and slow MACD line. The momentum is said to be growing when the histogram expands, while it is said to be weaker when the histogram becomes smaller.

Since MACD displays momentum, it would not be wrong to say that momentum would surge as the market follows a trend. However, in the case of MACD declines, then you can conclude that momentum is fading. This kind of behavior will indicate that the trend is going to end soon.

Relative Strength Index (RSI)

Popularly called as RSI, Relative Strength Index is a momentum indicator that is applied for knowing reversal breakouts. You can know the changes between the lower and higher closing price for a specific period. RSI can be applied to identify divergences, which in turn will help us to know possible trend reversals.

RSI is also used to know if a trend has been oversold or overbought. If the RSI is noted above 70, the market is overbought, and if it is below 30, the market is oversold.

What is Fakeout?

Fakeout or false breakout is a term used in trading to describe a situation where the price of an asset briefly moves beyond a certain level, triggering a buying or selling signal, but then quickly reverses course and returns to its previous position. This can result in traders being trapped in losing positions, as their trades are based on false signals.

How to Detect Fakeouts?

Detecting fakeouts can be challenging, but there are some strategies that traders use to try and identify them. One approach is to look for signs of divergence between the price of an asset and technical indicators, such as oscillators or moving averages. This can help to reveal when the price is overextended and due for a reversal.

Traders can also look for patterns, such as double tops or bottoms, which may indicate that the price is likely to reverse. Additionally, monitoring trading volume can provide insight into whether a move is likely to be sustained or is more likely to be a fakeout. Ultimately, detecting fakeouts requires careful analysis of market conditions and an understanding of technical analysis principles.

Fake Out Trading Strategy

Before even you know how to trade fakeouts, you should know where these fakeouts can occur. Usually, they are seen around resistance and supported levels that are created by chart patterns, trend lines, or previous daily lows or highs.

Trend lines

When there is a space between price and the trend line, then it indicates that price is moving more as per the trend direction and far from the trend line. This type of scenario helps to identify fading breakouts in case of trend lines. In the example below, the space between price and the trend line helps price to move back close to the trend line, probably even breaking it, and hence offering fading opportunities.

Don’t forget to focus on the speed of price movement. If the speed is fast towards the trend line, then it could be a successful breakout.

However, if the price is moving slowly towards the trend line, there is all probability of a false breakout.

Thus, the question that pops here is, how actually to fade trend line breaks. Traders can initiate a trade when price moves back inside the trend line. In the earlier example, the possible entry points are:

Chart Patterns

Chart patterns can be explained as physical groupings of price. They form a vital part of technical analysis and helps traders in their analysis. The most common patterns where traders can find false breakouts are as below:

• Head and Shoulders
• Double Top/Bottom

Head and Shoulders

The head and shoulders chart pattern is an indication of a reversal. They are known for creating false breakouts and giving opportunities for fading breakouts.

In this kind of breakout, put a limit order inside the neckline and set a stop loss above the high price of the fake-out candle.

Double Top/Bottom

In case of double top/bottom pattern, when price moves below the neckline, it indicates a possible trend reversal.

Double top formation fakeout happens when countless traders put their entry orders close to the neckline. To deal with this fakeout, put your order after price moves back. Define the stop loss close to the fake out candle.

False Breakout Indicator

False breakout indicators are technical analysis tools that traders use to try and identify potential fakeouts in the market. One such indicator is the Average True Range (ATR), which measures the volatility of an asset over a specific period of time. If the ATR is low, it may indicate that the asset is unlikely to experience a significant breakout.

Another false breakout indicator is the Donchian channel, which plots the highest high and lowest low of an asset over a specific period. Traders can use this indicator to identify when an asset is trading within a range and is unlikely to experience a genuine breakout.

Additionally, traders may use other technical indicators, such as Bollinger Bands or moving averages, to help identify false breakouts. Ultimately, false breakout indicators are just one tool in a trader’s toolkit and should be used in conjunction with other forms of analysis to make informed trading decisions.