False Breakout in Trading

Many Forex traders like to trade around key levels and frequently face false breakouts. It’s safe to say that false breakouts are a common challenge for anyone using this strategy. Key levels are points on the chart where the price has previously bounced or consolidated. Levels below the current price are known as support, and levels above are called resistance. Trading this way helps minimize risks and offers clear points for setting stop-loss and take-profit orders.

Formation of a False Breakout

In the market, prices move between support and resistance levels, which can lead to either a breakout or a bounce. False breakouts are a common occurrence in Forex trading. Most traders prefer to sell at the top and buy at the bottom. A false breakout is essentially a trick played on the majority of market participants.

During this phase, the support or resistance is tested. If there are major players ready to move the price in the current direction, a true breakout will occur, continuing the current market trend. However, detecting whether a breakout is genuine or likely to be false can be tricky.

In the case of a false breakout, large players push the price beyond a level, giving the majority a false signal that the price will continue in that direction. Meanwhile, these large players gradually take positions in the opposite direction at more favorable prices. Once they have accumulated the necessary volume, they profit from the stop-loss orders of the majority, as the price rapidly moves in the opposite direction after returning below the level.

Trading a false breakout involves taking a position in the opposite direction of the failed breakout and setting stop-loss orders above or below the consolidation level, depending on the breakout direction. This approach allows traders to use false breakouts to their advantage, turning potential failed breakouts into profitable trading opportunities.

Types of False Breakouts

1. False Breakout of Support Level

• Description: The price breaks below a support level but then quickly moves back above it.
• Example: The price drops below a support level, attracting sellers, but then sharply reverses and starts rising, causing losses for the sellers.

2. False Breakout of Resistance Level

• Description: The price breaks above a resistance level but then quickly moves back below it.
• Example: The price rises above a resistance level, attracting buyers, but then sharply reverses and starts falling, causing losses for the buyers.

3. False Breakout of a Channel

• Description: The price temporarily moves outside the boundaries (trendlines) of a price channel (up or down) but then returns back within the channel.
• Example: The price moves above the upper boundary of an ascending channel, attracting buyers, but then returns back into the channel and continues moving sideways.

4. False Breakout of a Triangle

• Description: The price temporarily moves outside the boundaries of a triangle pattern (up or down) but then returns back within the pattern.
• Example: The price breaks below the lower boundary of a descending triangle, attracting sellers, but then returns back into the triangle and starts rising.

5. False Breakout of a Flag

• Description: The price temporarily moves outside the boundaries of a flag pattern but then returns back within the pattern.
• Example: The price breaks below the lower boundary of a flag pattern, attracting sellers, but then returns back and continues the upward trend.

How to Trade False Breakouts on FOREX

When a beginner starts learning trading, one of the first strategies they often try to master is the breakout trading strategy. Whether it’s a breakout from a range or a chart pattern, the idea of the “breakout” strategy is to capitalize on a strong trend impulse by entering a trade at the beginning of the trend.

“Buy just above previous highs!” – says the basic breakout trading strategy.

The breakout trading strategy makes sense. Sooner or later, a trade using this strategy will be able to yield a significant profit.

However, the challenges are:

• Exiting the trade close to the end of the trend to capture most of the movement is not an easy task.
• Before such a successful trade occurs, there will typically be a series of false breakouts where the price breaks out of a pattern only to quickly return back.

Regardless of the type of false breakout (FB) encountered in the market, it is a clear signal for further price movement in the opposite direction. To trade correctly, you should wait for the price to return back under the level. Many traders prefer to wait for a small consolidation of the price near the level.

Buying positions

The position is opened in the opposite direction of the false breakout. Then, the stop-loss is placed beyond the level, above or below the consolidation, depending on the market price direction. The take-profit should be set at the nearest level on the chart.

Selling positions

You can also enter a position after a false breakout without waiting for consolidation, using Price Action patterns. In this case, the stop-loss should be placed according to the rules of working with the specific pattern. As in the first case, the take-profit can be set at the nearest level or according to the rules of working with the particular model.

Risk Management When Trading False Breakouts

Trading false breakouts can be highly profitable, but it also comes with risks. Effective risk management is crucial to protect your capital and ensure long-term success. Here are some key principles and strategies for managing risk when trading false breakouts:

1. Use Stop-Loss Orders

• Placement: Place your stop-loss just beyond the level of the false breakout. If you are trading a false breakout above a resistance level, place the stop-loss above the resistance. If trading a false breakout below a support level, place the stop-loss below the support.
• Example: If the false breakout is above a resistance level of 1.2000, place your stop-loss at 1.2020 to limit your loss if the breakout turns out to be genuine.

2. Calculate Position Size

• Risk Per Trade: Determine how much of your trading capital you are willing to risk on a single trade. A common rule is to risk no more than 1-2% of your capital per trade.
• Example: If you have a $10,000 trading account and decide to risk 1% per trade, your maximum risk per trade would be $100.

3. Set Realistic Take-Profit Targets

• Placement: Set your take-profit target at a realistic level based on the nearest significant support or resistance level, or according to the rules of the Price Action pattern you are using.
• Example: If the false breakout occurs at a resistance level of 1.2000 and the next significant support level is at 1.1950, set your take-profit at 1.1950.

4. Risk-Reward Ratio

• Calculation: Ensure that your risk-reward ratio is favorable, typically at least 1:2 or higher. This means that the potential reward should be at least twice the amount you are risking.
• Example: If your stop-loss is 20 pips away, your take-profit should be at least 40 pips away.

5. Use Trailing Stops

• Adjustment: Use a trailing stop to lock in profits as the trade moves in your favor. This way, if the price reverses, you can still secure some of your gains.
• Example: If the price moves 30 pips in your favor, you can move your stop-loss 20 pips in the direction of the trade to secure a portion of your profit.

6. Avoid Overtrading

• Discipline: Stick to your trading plan and avoid overtrading. Only take trades that meet your criteria for a valid false breakout.
• Example: If your strategy calls for only one or two trades per day, resist the urge to take additional trades that do not meet your setup criteria.

7. Monitor Market Conditions

• Awareness: Be aware of overall market conditions and news events that could impact your trades. Avoid trading false breakouts during highly volatile periods or major news releases.
• Example: Avoid trading during the release of major economic data, such as Non-Farm Payrolls or central bank interest rate decisions, as these events can cause unpredictable market movements.

Conclusion

A false breakout in Forex is a very common signal indicating a change in the direction of price movement. It acts as a kind of trick on the crowd, as many participants jump into a position when a breakout occurs without waiting for its confirmation. As a result, they incur losses because the price changes direction and moves back below the level. At this point, many participants’ stop-losses are triggered, causing the price to sharply move in the opposite direction after the false breakout.

Considering this, it can be confidently stated that a false breakout is a signal indicating a change in the current direction of price movement. To avoid falling into this trap, it is recommended to use VSA (Volume Spread Analysis) or Price Action trading patterns, which help determine the real picture of what is happening in the market. For example, with VSA, if a breakout occurred without significant volume, it is likely to be a false breakout. Additionally, using false breakout trading strategies can help you identify false breakouts and trade them intentionally to your advantage. One of the simplest ways to avoid a false breakout is to wait for confirmation before entering a trade, ensuring the breakout is genuine rather than a false breakout.