Breakout trades explained. We discuss breakouts as a trade signal/trigger, why there are two strategies: to jump a breakout or to fade or trade against one.
Breakout setup as a simple trade signal/trigger
Many traders use breakout setups to trigger a trade. A trade is placed when price penetrates an existing horizontal support or resistance, or an existing trend line that acts as support or resistance. When a breakout happens, traders assume that it is the signal for the start of a new move. Such a trade is usually called a ‘breakout’ trade – the action of price crossing support or resistance provides a trigger i.e. trade signal to open a position.
Trend line break signals, horizontal support/resistance break signals
Danger of trading breakout signals
Breakout trades appear fairly obvious on back testing but applying it during actual trading is not. That’s because it is easier to spot signals that actually happened but for every successful breakout trade, there are scores of failed ones that are hard to spot. Failed breakouts are pretty common – price moves across a trend line or horizontal support or resistance creating a breakout signal but quickly U-turn and move back across the threshold.
False breakout signals
Failed breakouts actually names like ‘wash and rinse’, ‘bull trap’, ‘bear trap’, ‘stop hunting’ etc.
Sophisticated traders try to combine a breakout trade signal with a time element. For example, a trend line is presumed to be broken if price is able to cross a trend line and stay on that side of the threshold by X time. This time plays the role of a restraint or filter. If price returns across trend line before the end of the duration, the observed trend line break is a false one. The reason to apply such a setup is to avoid false breakouts.
Is there a reason behind false breakouts?
Trades long suspect that false breakouts are not truly ‘natural’ price finding action but something more sinister – that there is an ‘invisible hand’ in the market manipulating price movement, herding traders into a trap. Whether there is such an invisible hand each trader has to make up his own mind but this is how it is supposed to work – just imagine what you would do IF YOU ARE THE INVISIBLE HAND.
Why does price go up?
- Push price up to kill short sellers
- Suck in buyers to buy more expensive; make them push together with you
- Reach the top and push past one more time to trip stops of short sellers (aka stop hunting)
- Suck in MORE BUYERS who trade break out
- Unload your position to them!
Why price goes down?
- Unload and SELL on your way down.
- Trip stops of buyers; make them join your push down
- Keep pushing down to kill more buyers
- When they give up and decide to turn short, YOU BUY!
- Rinse and Repeat!
And that’s how you make money from both sides
Examples of false breaks
These are excellent examples of how false breakouts can herd unwary traders into traps.
XAUUSD following 2016 US Presidential Election
Here’s an example from XAUUSD that happened late last year just after the US Presidential Election on 08 November. In this example, 2015 high formed a resistance level based on merit as a 52-week high, which became a support for most of Q3 2016. Price subsequently broke down. In the context of gold, there is a huge camp of gold bulls who feel that gold price deserves to go higher. Look at the spike at the last black candle. This is a weekly chart. In the lower time frames, there was a breakout above 2015 high at 1307 which subsequently failed in a big way. That tail left by the candle is what a false breakout looks like. Consider that the stop losses of a lot of early bears got killed here but a lot of bulls who went long when price broke above 1307 also got killed by the following U-turn.
Note I wrote a post on 11 November 2016 about this phenomenon. XAUUSD was not the only trade that had a false break. Documented includes AUDUSD and NZDUSD.
XAUUSD price action showing a bull trap post-US Presidential Election
Brexit GBPUSD pump and dump
This chart was captured on 30 June showing GBPUSD price action leading up to and after Brexit. Note again this weekly chart which shows GBPUSD rising above previous week highs and then capitulating in a horrendous move.
Post-Brexit pump and dump in GBPUSD
False breaks leading up to and after recurring high impact news like FOMC, ECB Press Conferences
Going a little further back with recurring events. I have a comprehensive writeup here but lets look at just the charts and illustration. Point 1 and 2 both mark false breaks.
USDSGD chart from 06 June 2014 – day following ECB Bid Rate and Press Conference
The next chart is a continuation from the one above. See point 3 which shows a spike above horizontal level followed by failure.
USDSGD chart from 19 June 2014 – day following FOMC
Fading a false breakout as a signal/trigger
Since jumping into, attempting to ride a breakout is fraught with danger, it is possible to use a failed breakout as a trade to ‘fade’ against the break.
Traders who jump into breakouts see a price break leading to new movement/trend. They also see trend line, horizontal supports and resistances as more likely to break. Traders who fade breakouts favour trend continuation. They also see support and resistance as levels to comply with.
This illustration below shows how jumping breakouts and fading breakouts work.
- In bullish break example (in blue), bulls jump into long positions when price crosses resistance. Bears short when price crosses back below resistance.
- In bearish break example (in red), bears jump into short positions when price crosses below support. Bulls go long when price crosses back above support.
How fading a false breakout works
An example of fading a false break
In this example documented 02 June 2016, we have multiple JPY crosses which are already in down trend spiking above resistance. Instead of going counter-trend long on a breakout of resistance trade, we have readers going fading breakout for a with-the trend short.
SGDJPY weekly chart showing strong zone at 80; chart captured on 02 June 2016
This first chart ↑ shows the resistance (in yellow) on the higher time frame (valid as far back as 2014).
This daily chart shows a 3-day false break across a more than 2-weeks resistance
This is a screengrab contributed by a reader who faded false breakouts in GBPJPY and CADJPY during this time.
Reader contributed screen capture of winning GBPJPY and CADJPY shorts by fading a false breakout
Which strategy works better?
There are many elements in a trading strategy. A trigger is only a part which has to fit well with all other elements. There is no absolute right or wrong. Personally I prefer to trade with the trend and to use a false break as an entry signal (to fade). This is a story to take up another day. In my opinion, traders have to be aware of possibilities that show up in the market. Better be aware and to incorporate these many possibilities into trade planning, evaluation of risk. However if there is one tip I can share with you regarding breakouts, that is the stronger and more significant a support or resistance is and the stronger and more significant the trend is, the more fruitful it is to trade with the trade i.e. to fade any counter trend breakouts.
If you like this story, I encourage you to read this one ‘5 price features that set up a good reversal trade‘. Happy trading.
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Soh Tiong Hum is Director of TerraSeeds Market Technician Pte Ltd. TerraSeeds is a trading educator in Singapore since 2005.
Soh's Twitter account @sohtionghum
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"I do not have a financial advisor's license. I am not qualified by any regulator to give financial advice. I do not know you the reader. Your investment means and motive may be different from me. My posts here are based on observations and meant for education. I am not responsible for for any consequence from your actions."