One of the more frustrating experiences when trading Forex is the false breakout. It often comes on the heels of a perfect price action patternthat seems to have everything going for it. You set your pending order, the market breaks out as expected, but before you know it the market has fallenback inside the aforementioned pattern and now you’re facing a potential loss.
Why did this happen? Better yet, how can you mitigate the risk of a false breakout?
That’s exactly whatyou’re about to learn in this lesson. We will cover the characteristics of a false breakout, why they occur as well as what you can do to protect yourself.
What is a False Breakout?
A false breakout, also called a “failed break”, is a price movement through a support or resistance level that lacks themomentum necessary to maintain its direction. In other words, the market fails to produce enough supplyor demand to validate the break of a key level.
Belowis an illustration of a false breakout.
In the illustration above, the market hasformeda wedge pattern. As the consolidation became tighter, the market broke to the upside but was unable to maintain enough bullish momentum to hold above the level. In other words,the market lacked the demand to push prices higher after the breakout occurred.
If you had enteredlong as soon as the market breached the resistance levelyou would have been caught in a false breakout. Once in a trade like this you’re confronted with two decisions – either stay in and “ride it out” or exit for a small loss. Neither option sounds very appealing.
In order to reduce the chances of this happening in the future, we need to add an additional requirementto our trading plan.
Mitigating the Risk of a False Breakout
I recently wrote a lesson on my favorite Forex breakout strategy. In that lesson, I detailed a trading strategy that works great for catching an increase in volatility as the market breaks out from consolidation.
Although it’s a very effective strategy, we all know thatthere’s no such thing as a sure thing when it comes to trading Forex. We also know that there’s no way to completely avoid losses. But what if I told you that there’s a way to reduce the likelihood of experiencing a false breakout?
The very best way to protect yourself from false breakouts is to wait for a closebelow or abovethe support or resistance level respectively. It isn’t enough for the market to simply move beyond a level.We need to see a close outside of the level in order to validate the setup.
Let’s comparethe difference between the two usingexamples from the USDJPY daily chart.
Notice how on the first attempt to move beyond resistance, the market wasn’t able to maintain enough bullish momentum to close above the level. This happened on several occasions over a five day period. Traders who simply placed a pending buy order above the resistance level would have experienced a loss; or at leasta considerable amount of stress as they watched the market move against their position.
The traders who waited for a daily close above the level would have experienced a nice gain on this trade. By simply waiting for a close above the level, we can confirm the strength of a breakout, giving the setup a greater chance of succeeding.
Which Time Frames Are Best?
This is perhaps the most important topic when it comes to reducing the chance of afalse breakout. The technique we just learned is best used on the higher time frames. Which time frames exactly? As a general rule, anything above the 1-hour time frame works the best.
Most of the breakouts that I trade are on the 4 hour and daily charts. Both time frames work great, but I do recommend the daily time frame for beginners. This is because the higher time frames generally produce the most reliable setups.
Learning Patience
It can be challenging at first to wait for several hours or even days to confirm a breakout. For most traders,the challenge is born from a fear of missing out on a trade.If you ever feel this fear creeping into your mind, just remember that there are often multiple opportunities to enter a breakoutsetup. In fact, the market will often retest former support or resistance after the break, giving you a great opportunity to enter the market.
If you’re nervous about missing the trade by waiting for the candle to close, there’s a good chance that your risk to reward ratio is off. By “off” I mean not favorable enough to justify the trade setup. For example, a 4R setup is not going to be adversely affected by waiting for a candle to close. You’re farbetter off tradinga 3R setup that hasa confirmed breakout than a 4R setup that leaves you holding your breath.
It All Comes Down to Probabilities
As a technical trader, you know that it all comes down to probabilities. The morefactors you have in your favor on any given setup, the greater the odds are that that setup will result in a profit. When it comes to the Forex breakout strategy, the key factor is waiting for a close above or below a key level.This is what gives thesetup validity and helps you mitigate the risk of a false breakout.
Summary
I hope this lesson has provided you with a way to further increase yourodds of successfully trading Forex breakouts. Although there is no way to completely avoid false breakouts, the information provided in this lesson will surely help you to reduce the risk.
Key points from the lesson:
- A false breakout is also called a “failed breakout”
- A false breakout occurs when a market moves through support or resistance but doesn’t have enough momentum to maintain its direction
- The best way to mitigate the risk of afalse breakout is to wait for the candle to close above or below the key level before considering an entry
- The two best time frames to confirm a breakout are the 4 hour and daily time frames
- Waiting for a close above or below a key level is the bestway to increase your odds of success when trading the Forex breakout strategy
Your Turn
How do you avoid false breakouts? Leave your comment or question below.
I look forward to hearing from you.
