One of the more frustrating experiences when trading Forex is the false breakout. It often comes on the heels of a perfect price action pattern that 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 fallen back 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 what you’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.
A false breakout, also called a “failed break”, is a price movement through a support or resistance level that lacks the momentum necessary to maintain its direction. In other words, the market fails to produce enough supply or demand to validate the break of a key level.
Below is an illustration of a false breakout.
In the illustration above, the market has formed a 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 entered long as soon as the market breached the resistance level you 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 requirement to our trading plan.
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 that there’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 close below or above the 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 compare the difference between the two using examples 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 least a 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.
This is perhaps the most important topic when it comes to reducing the chance of a false 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.
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 breakout setup. 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 far better off trading a 3R setup that has a confirmed breakout than a 4R setup that leaves you holding your breath.
As a technical trader, you know that it all comes down to probabilities. The more factors 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 the setup validity and helps you mitigate the risk of a false breakout.
I hope this lesson has provided you with a way to further increase your odds 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:
How do you avoid false breakouts? Leave your comment or question below.
I look forward to hearing from you.