False Breakouts Patterns- Identifying, Avoiding & Handling

What is a False Breakout in Trading?

Most traders begin by learning about support and resistance and how to trade them when the price breaks out of those levels. This is known as “breakout trading.”  However, not all breakouts work, and the price can go back to the original support or resistance levels creating a “failed”, or “false” breakout.

Let’s take this idea step-by-step:

1. The price forms a support or resistance level.

2. The price breaks through the level.

3. After the breakout, the price reverses and returns to the original area.

Failed Bullish Breakout

Failed Bearish Breakout

The Difference Between a Failed Break and a Test

The price can break a support or resistance level, but not break through it decisively—this is what is called “testing the level”. The key takeaway is that a breakout must be decisive for it not to be a test. Decisive moves will produce a long candlestick with short wicks (or a series of candles like this).

Let’s look at some examples of price testing a level without true breakouts on an hourly EUR/USD chart:

A Retest

1. The price forms a clean resistance level.

2. Price comes up to test point 1. Technically, it breaks through by a few pips but very quickly retraces.

3. The price significantly breaks through the level established at point 1. I can understand why traders may see Point 3 as a valid breakout, even though it failed, but to me, it was a test and not a breakout because of the shape of the candle (a bearish pin bar) and the fact that the following candle does not sustain bullish momentum.

4. Again, the price comes up to test the resistance, but it doesn’t hold the bullish momentum, so the candle has a long wick and small body.

Even though the price broke through the resistance level established in point 1, it never stayed above the price by a significant number of pips or for multiple candles after each break. In my opinion, these were tests and not breakouts.

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What Does a Failed Breakout Tell You?

A failed breakout tells you the price is not yet ready to move beyond the support or resistance level. Yet a failed breakout does not automatically mean the price will reverse and start a trend in the opposite direction. The price can make a second attempt to break out and this time succeed, as in the example shown in the price chart below:

Successful Breakout on Second Attempt

Your Psychology and False Breakouts

Managing your psychology is very important during trading, especially when you are using a breakout trading strategy, because the price goes back and forth and plays with your emotions.

The psychologically hardest part is the initial breakout when there is often a strong candle or series of candles breaking through a support or resistance. Why is this part psychologically hard? Because you get a classic case of FOMO (fear of missing out) —you see a strong move and are afraid of missing it, so you are tempted to jump into the market even if the entry level you would ideally want to take has already been passed. Everyone is susceptible to this psychological feeling, even disciplined and experienced traders. Disciplined traders trade according to a trading plan and not according to the whims of their emotions.

Example of a Failed Breakout Trade

Here’s a textbook false breakout pattern in a trade I took, shown below in an S&P 500 daily chart.

Failed Breakout Trade S&P 500 Index

Let’s go through the trade step-by-step:

1. A resistance level forms at 4745. After the price hits this level on two occasions, the market sells off heavily, showing potential weakness. So, 4745 became an obvious resistance level.

2. A long bullish candle decisively breaks through 4745. I saw this as a breakout of the resistance level and not a test of the level.

3. After the market moves sideways for 6 candles, there is a steep bearish failure candle. The failure candle is even more decisive than the breakout candle. I like seeing two strong candles in opposing directions near each other because it indicates a convincing reversal in sentiment.

4. After the breakout failure, the price re-tests the resistance level and forms a strong bearish candle. For me, this confirms the bearish short trade setup, and gives a great entry opportunity.

The biggest risk I saw here was that I was entering a trade against the previous bullish trend: the market had been trending up for nearly two years. Usually, I like to take trades in the direction of the long-term trend. However, here I was willing to enter a short trade because of the significant bearish factors shown within the failed breakout pattern, which I explained in the numbered points above.

This trade worked out nicely, and my false breakout strategy helped me enter the market at the start of a new six-month downtrend.

How to Identify and Avoid a False Breakout (in Forex and other markets)

The easiest way to avoid false breakouts in Forex and other markets is to always wait for the previous level to be re-tested from the other side before entering a trade. An example of such a clear retest is shown in the price chart below. Note how the price breaks above the resistance, and then it holds very cleanly as support, suggesting we have seen a decisive, true, successful breakout beyond the resistance level.

Successful Breakout as Resistance Becomes Support

The disadvantage of waiting for this confirmation method is that the market can continue going without a retest, and you miss the trade.

When you look at how to trade breakouts in Forex or other markets, you can also consider other confirmation tools, such as moving averages for example, to see if momentum is in your favour. Perhaps one of the most effective methods you can use to identify a breakout which is more likely to succeed and keep going, is if there is a period of narrow range consolidation just before the breakout. Breakouts like these tend to have better chances of travelling a considerable distance in the direction of the breakout.

A False Breakout Strategy: Step-by-Step

1. Wait for a clear support or resistance level to become easily identifiable. The clearer, the better!

2. Then, wait for the price to break past the support or resistance level decisively.                                                                            

3. The price may retest the broken level from the other side. For example, a broken resistance turns into support. When this happens and the level holds, the breakout is more likely to not be a false one.

4. If the price goes back through the broken level where it came from, it’s a false breakout. Note that this does not guarantee that the price will reverse the trend significantly.

5. There are several entry methods at this failure stage: the price respects the previously broken level again to give you an entry (e.g., the previously broken resistance acts as resistance once more). Another popular but more aggressive method is to place an entry order above or below the candle that first broke out of the level (e.g., a sell stop order below the bullish breakout candle for a short trade).

Resistance Breaks Then Holds Again

Pros and Cons of Trading Breakouts and Failed Breaks 

Riding an established trend is way easier than trading breakouts, although of course you can trade breakouts in the same direction as the trend as part of trend trading.  Within trends, you will also see false breakouts on lower timeframes that continue the higher timeframe trend and provide excellent entry opportunities. Here’s a list of the pros and cons of trading breakouts and failed breaks to help you decide whether this kind of trading is for you.

Pros of Breakout Trading

• You will always be trading with short-term momentum in your favour, which can be a powerful edge in Forex.
• If you take every qualifying breakout, you won’t miss any big winners.
• Breakouts in line with the trend contain some of the best technical edges in the Forex market, especially in major currency pairs such as the EUR/USD and the USD/JPY.
• When a breakout is preceded by low volatility, an explosive move in the direction of the breakout is more likely.

Cons of Breakout Trading

• It takes experience to learn which breakout or false breakout set-ups are more likely to be successful.
• Breakout traders have a low win rate, so you will experience a lot of losing trades.
• Breakout trading can be messy and emotional. You will often get stopped out only to see the trade go on to become a big winner if only you had used a wider stop.
• Tight stop losses above recent highs or lows are vital, which may be hard psychologically for some traders to implement.

Bottom Line

Trading breakouts, whether as breakouts or as false breakouts, can be the basis for successful, profitable trading, whether in Forex or other asset classes.

A false breakout can be a trap if your emotions let you enter trades too early. Instead, it tends to work out better if you apply a lot of self-control and wait for the price to confirm whether a breakout is real or false, using the methods explained earlier within this article to make that call. You can then plan your trades intelligently based on price action.

It is very important to always trade with a stop loss. You should make sure that you place a stop loss at a point where you feel the trade will be proven wrong if the price reaches it, or even tighter than that, based upon volatility. It might feel counter-intuitive, but as the best, most profitable breakouts tend to move very quickly, using very tight stop losses in breakout trading is likely to give you a high loss rate, but a highly positive overall expectancy. A great thing about breakout trading is that the winning trades tend to produce excellent risk/reward ratios when tight stop losses are used.