How to Trade with False Breaks

Most traders live for breakouts. Indeed, scalpers and intraday traders pine for them. Not only can traders reap enormous profits, but the thrill of trading breakouts can make the whole venture even more worthwhile. Breakouts can start trends, but also illuminate longer term trends as well, providing confirmation to fundamentals and sentiment.  It can be described like a thunderstorm where the sky opens up, lightening strikes, things go boom, and all is clear afterwards.  

The only drawback, is the market likes to play games with traders. We’ve all experienced it.  A currency pair makes a sharp move, we climb aboard for the ride, and then the trade reverses sharply. Often, the distance measured in pips-or cents in the case of commodities-is very little. Disappointment reigns, as most breakouts are of short duration or distance, more akin to false breaks than true breakouts. The reason for this is simple. Volatility and liquidity. A brief infusion of funds and traders, or increasingly,  machines trading algorithms.  True trends and reversals, happen far less frequently than many traders realize. Here are a few observations: 

A confluence of events. Breakouts tend occur due to news events-expected and unexpected-as well as events which confirm and deepen market conviction. The strongest breakouts occur when news events synchronize with other actions taking shape in other financial markets, such as equities or bonds. They also tend to occur after quiet periods where the market had been range bound, and where price action had been reduced to an ever tightening band over a period prior to scheduled news releases. Often, the breakout is preceded by a shorter spurt of price activity immediately or soon after news events. This however, is often a false breakout and more likely the result of traders shifting their positions due to, or anticipation of the news. Those traders whom want to get in at the very top or bottom of moves will often find themselves being shut out in fast moving markets, or stopped out in volatile ones. It’s usually far better to have a preset trade ready to go, or wait until the trading settles down and the direction is more clear. Of course, a trader may miss a good portion of the breakout, but the risk of latching on to a false breakout is reduced. This is all predicated on a trader having a sound plan, being able to match the breakout with his or her analysis on the market. Often, traders whom follow the herd and go off the cliff when they ignore their own analysis and instincts, getting caught up in the excitement of the move.

Confirm, reconfirm, and do it again. Also called, a confluence of indicators. Traders will want to monitor fundamentals to confirm the underlying impetus for breakouts, but also see if they technical indicators (a detailed confirmation of fundamentals) support a position and trend direction. Often times, there is short term divergence or simply market gyrations at work, and prices may snap back to their original trajectory after traders adjust their positions. Traders should always refer to the general sentiment of the Commitment of Traders reports. While these can lag the changes in market direction since the reports are complied on Tuesdays (but released on Fridays), and much of the most significant market news can occur on Thursdays and Fridays, it’s good to see what the larger traders are doing since it’s a bit more difficult to turn around the “S.S. Titanic,” than a smaller ship…namely your account.  Traders also want to match trades to their technicals, specifically those that are good for gauging breakouts. Some of those indicators include: support and resistance levels, moving averages (watching for crossovers and separation between the averages, as well as price action), Fibonacci, Bollinger Bands, Donchian Channels, as well as pivot points. Trend lines can also be drawn to see if price activity is within the boundary of an overall trend, or has truly broken beyond. 

Don’t compromise trade setups. The cardinal rule of successful traders. The tendency of many traders is to jump into a trade when they see price action moving. Go in ONLY after your signals are lined up, not before. You may miss some awesome trades, but over the long term, it will save your account. The game is a marathon, not a sprint…though breakouts can inspire us to become different types of traders. 

Patience like a military sniper. The most steely eyed traders will wait for the perfect setup. It’s a hard discipline and traders will want to jump at the first sign of movement, but the best traders will sit on their hands until KEY support and resistance levels are broken, particularly those on 4hr and daily charts. Trade the lower time frames, but keep an eye on these. 

Scalping anyone? Breakouts were made for scalpers. They live for them and are the happiest when they can catch them…all of them. The challenge however, is the same as for sluggers in the American sport of baseball. The best will get home runs, but the number of strike outs far exceeds the big hits. As a trader, one has to ask oneself, can I afford to strike out more often than I win? The answer is yes, if the trader can adjust him or herself to losses by a very tight money and risk management system which they do not waver from. Those disciplined souls-and they are rare in the forex game-can reap quick and consistent profits. Most traders however, need to have a longer term, more balanced approach. Another way to do this, is to scalp in a separate account, with fewer funds than in a swing or longer term trading account. 

Opposites attract. The other side of movement is…movement.  For every reaction there is an equal and opposite reaction. Sort of like the law of physics, though not exactly conforming to the rule. However, price action does resort to the mean and any study of charts indicates that price action does retrace. Think of how often Fibonacci levels are reached. The point here is that traders whom are prepared for reversals, are more likely to be successful. 

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