Trading Breakouts and Fakeouts in Depth Overview

Ways to trade breakouts

A breakout is noted when the price moves out of some trading range or consolidation. It can also be noted when a certain price level is broken, including the resistance and support levels. Breakout is an indication that the traders must enter the market when there is a breakout in price and then remain in the trade until volatility comes down.

Focus on volatility

In the forex market, the focus should be on the volatility as there is no way of knowing the volume in the forex market. In stock trades, volume plays an important role in understanding the breakouts, which is not the case in the forex market. Hence, the traders have no choice but to depend on good risk management and certain criteria to position themselves for a potential breakout. When there is significant price movement in a short time, at that time the volatility is said to be high. If there is little change is the price in a short period, then volatility is low.

Traders may get tempted to enter the market when prices are moving faster on either wide. However, without analyzing the trends, if they enter the market, the money will go in, without any good probability of making profits. High volatility is one of the factors that make the forex market quite interesting, but then it is volatility only that eats up the money of lot many traders. Hence, the objective here is to use the volatility as per the breakout and make money.

How to Measure Volatility

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.

Types of Breakouts

The Different Types of Breakouts

Breakouts are important because they suggest a change in the demand of the pair you are trading. The change in sentiment can lead to substantial price moves that offer remarkable opportunities to make some money. 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 breather 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.

How to Trade Breakouts Using Trend Lines, Channels and Triangles

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

How to Measure the Strength of a Breakout

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.

How to Detect Fakeouts

Ways to Detect Fakeouts

It is common for traders to confuse fakeouts with breakouts. When price breaks out of the resistance or support level, it is expected to move in the direction of the breakout. However, before jumping to take the trade, wait for the trend confirmation. Many times it happens that after a possible breakout, the price reverses its momentum. Instead of moving into the direction of the breakout, it suddenly starts trading in the opposite direction.

Eventually, it confuses traders, and they cannot make it out what should be their next step. They get stuck in the wrong trade.

So, what is important here to understand is that the resistance and support levels are tricky. These are the areas where an expected price response can be seen.

Support levels can be defined as the price zones where buying pressure is enough to counter selling pressure and reverse or halt a downtrend. You should know that a strong support level will continue to exist even if the price goes below the support level. It will offer traders a good buying opportunity.

Resistance levels work oppositely as that support levels. They tend to reverse or halt uptrends. Resistance levels mark the zones where selling pressure is enough to counter buying pressure and lead in price back down. Again if the resistance levels are strong, they will hold up even when the price goes below the resistance level. Traders tend to identify good selling opportunities by using resistance levels in trade their analysis.

Fade the Breakout

How to Fade the Breakout?

Yes, you read it right. It is fade the breakout and not trade the breakout. Fade the breakout implies that you should trade in the opposite direction of the breakout. In simple words, you can call fading breakouts as trading false breakouts.

You can fade a breakout when you think that the breakout from the resistance or support level is false, and as a result, it will fail to continue trading in the same direction.

In instances where the resistance or support level breached is significant, you should consider going for fading breakouts instead of trading the breakout. However, fading breakouts marks as a good short-term plan. Earlier breakouts may fail, but then there are chances they will succeed eventually. That’s why learning to trade false breakouts may help traders avoid getting whipsawed, at least for the short term.

There are reasons behind the forex traders getting interested in trading breakouts. Resistance and support levels are considered to be price ceilings and floors. If these levels are breached, you can expect the price to trend in the same direction as that of the breakout.

The price movement can go down when a support level is breached. However, more people will tend to buy when the price goes above the resistance level.

Usually, independent retail traders believe in taking trades in the direction of the price breakout. However, they tend to forget that breakouts can also fail. However, more seasoned traders and institutional traders like to fade breakouts. And then there are smarter forex traders who take benefit of the collective thinking of the inexperienced traders.

How to Trade Fakeouts

Ways to Trade Fakeouts

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.

Conclusion: Trading Breakouts and Fakeouts

The Basics of Trading Fakeouts and Breakouts

Trading breakouts help traders to take a trade at the right time and then continue to gain from the trade until volatility fades. Breakouts are essential because they suggest a change in the demand and supply of the currency pair being traded. Volatility focuses on the changes in price for a specific period. Many indicators help traders know a pair’s current volatility. These indicators are listed below:

• Moving Averages
• Bollinger Bands
• Average True Range (ATR)

When studied well, these indicators help us identify the breakouts at the right time. The two types of breakouts are listed as under:

• Continuation Breakout
• Reversal Breakout

After traders understand the types of breakouts, then they need to analyze different patterns, which can help them to spot breakouts. Traders can study the following patterns:

• Chart Patterns
• Trend lines
• Channels
• Triangles

In addition to understanding the patterns, it is also vital to know the strength of any breakout. This measure can be done by using the following indicators:

• Moving Average Convergence/Divergence (MACD)
• RSI

Usually, breakouts are supported by some news catalysts or economic event. Ensure that you are aware of the news and forex calendar before taking a trade on the breakout.

Trading Fakeouts

Traders can misinterpret fakeouts with breakouts and take the trade on the wrong side. So, extreme caution should be taken while initiating a trade. If traders feel that there is a false breakout, then they should fade a breakout, which means taking a trade in the opposite direction of the breakout.