Breakout Trading Strategy Revealed | How to trade breakouts and fakeouts
BY TIO Staff|May 11, 2022
Have you heard about the breakout trading strategy? Would you like to know how to trade it? Great, keep reading to find out.
In this article, I’m going to tell you about breakouts, fakeouts and the psychology behind them. Then show you how you can use these techniques to find trading opportunities, improve your entries and market timing.
So without any further delay, let’s get started.Try trading on our flagship VIP Black account, get ultra tight spreads, $0 commission and fast execution speeds. Open your account today.
What is a breakout trading strategy?
A breakout in trading and the financial markets occurs when an asset’s price breaks through an established resistance or support area. Which is then usually followed by a sharp increase in volume and a follow through in price in the original direction. Breakouts are often preceded by a period of price consolidation or range bound trading. That can last from minutes, hours, days, weeks or even months.
Once you begin to understand what breakouts are and how they work, you can then begin looking at how to trade them effectively. This article will cover everything you need to know about breakouts and what to do when they fail.
So keep reading to learn all about the breakout trading strategy.
Will a breakout trading strategy work?
The reason why breakout trading strategies are so popular in the trading community is because they are often one of the first methods traders learn in technical analysis. Breakouts occur regularly in all financial markets and across all time-frames. You can open any chart and see this fundamental behavior, that price establishes highs, lows and ranges, then breaks out of them.
So is it any wonder that traders will take this observation and create a breakout trading strategy from it?
Although breakout trading strategies don’t work all the time, they can help you anticipate future price movements, improve market timing and help you get in on trends early. And if the breakout isn’t successful, or it fails, there is an alternative scenario that might work instead.
This alternative is referred to as a fakeout or a false breakout.
Fakeouts (or false) breakouts
A fakeout is a false breakout or an apparent breakout that fails to materialize with price following through. It’s a term used in the financial markets to describe when the price of an asset breaks out of an established trading range, support or resistance area but only to return back inside the previous range.
If you’re trading breakouts, you want to buy when price breaks above a resistance level, and sell when it breaks below a support level. If you’re trading fakeouts, you want to do the opposite, which is to buy when price breaks through a support level and sell when it breaks through a resistance level.
Here is an example of price exceeding the previous highs where a resistance area was established. Only for the price to reverse and quickly move in the opposite direction. With the benefit of hindsight, we can see that this was a false breakout or a fakeout.
Why does the market do this?
The psychology behind breakouts and fakeouts
There are several reasons why that come to mind. The human brain is wired to seek out patterns; it likes to see things in terms of cause and effect. Because of this, when you see a price move outside its normal range over and over again and continue or reverse, your brain immediately wants to assign some kind of meaning or significance to it. This creates what psychologists call confirmation bias, where we tend to look for evidence that confirms our beliefs and ignore evidence that contradicts them. When traders begin seeing patterns in “random” price movements, they look for the cause and anticipate the effect.
Another reason why price breaks out or fakes out of support and resistance areas is because traders place their pending orders around these areas. These pending orders can be in the form of stop losses and market or limit orders to initiate new trades. We know that the market naturally gravitates to areas of liquidity to match buy and sell orders. So, when these orders are triggered, they add to the supply and demand dynamic of the market and cause prices to move away from them, in one direction or the other.
A breakout above resistance means that buyers have overcome sellers and are pushing prices higher. A breakout below support means that sellers have overcome buyers and are pushing prices lower. When prices fakeout of support or resistance areas, traders are usually positioned incorrectly or they have been stopped out only for the price to move in their intended direction without them.
Breakouts or fakeouts of consolidation areas tend to be more significant than other types of movements. This means that once prices break through support or resistance levels, they will often continue moving up or down or reverse because orders have accumulated outside of this range over time.
Liquidity outside of range
How to trade a breakout trading strategy
In order to trade breakouts, you just need a clean price chart, without indicators and obvious support and resistance areas marked in advance. A breakout occurs when price moves through an identified level of resistance or support and continues in the same direction.
The best way to trade breakouts is to wait until they happen, and preferably seek some kind of confirmation. By this time the market will already have given you some indication that it’s going to happen, so you don’t have to guess whether it will happen or not. When a breakout happens, take your entry and place stop loss orders just below the support or above resistance so that if your initial prediction is wrong, you won’t lose much money.
But what happens when a breakout turns into a fakeout?
How to avoid a fakeout (false breakout)
The simple answer is that you need to know when a breakout is turning into a fakeout.
The best way to avoid getting caught in a fakeout is by waiting for confirmation and using tight stop losses. That means waiting until a clear breakout occurs and the price has moved beyond support or resistance before you begin buying or selling.
Another way to avoid the false breakout is to trade in the direction of the longer term price trend.
Ultimately, you should practice on a demo account or a live account with micro lots!
How to trade a fakeout
A fakeout can actually be used as a signal or opportunity to trade as well under these circumstances. Once you have identified the direction of the price trend, and established support or resistance areas, you can wait for a fakeout to occur of either and enter when price reverts back into the range.
You can also use fakeouts to trade corrections against the dominant trend but the probability of success will probably be lower.
Let’s take a look at some examples.
Example of trading breakouts and fakeouts
In this example, you can see a breakout of resistance and the price continues to follow through to the upside.
The first step in this breakout trading strategy is to identify significant areas of support and resistance. Ideally, prices should be consolidated and be moving sideways within a range.
Once you have done this, then be patient and wait for the price to break out of this range before entering the market.
You can place a stop loss just below the previous swing high or low that preceded the breakout just inside the range. Basically, the ideal place to put a stop loss is at the soonest price where the breakout fails and potentially starts showing signs that it’s a fakeout. You can take the loss quickly and reverse your position or wait for another opportunity.
Then to identify potential profit targets and exit the trade, you can target the closest previous support or resistance area or recent swing high.
Here is a further example using a fakeout.
Like the previous example of trading breakouts, the first step is to identify significant areas of support and resistance. Then wait for a breakout to occur. If you enter on the breakout, you should watch for signs that price won’t follow through and a reversal back inside the range.
If this happens, there is a chance that the breakout is actually a fakeout and you should exit your trade and possibly consider reversing your position. Profit targets can be the most recent support or resistance area or recent swing highs or lows.
Breakout trading is a strategy where you buy an asset that has broken out above resistance, or sell when it has broken out below support. When this happens, you can enter the market just before a potential price move gets underway. The price doesn’t follow through all the time though, sometimes breakouts fail and these are referred to as fakeouts or false breakouts. Fakouts occur when the price temporarily moves above or below the support or resistance area before reversing and moving in the opposite direction.
Breakouts and fakeouts can provide excellent trading opportunities but you need to be patient and disciplined and practice to use them successfully. You should wait until your breakout signal occurs before entering the market and seek additional confirmation that it is a valid one.
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