A pair trades in a range and then breaks out. You go with the breakout, buying high to sell higher or selling low to cover on lower ground. But after breaking out of range, the pair returns to the range, hitting your stop-loss and the trade is unsuccessful.
I’m sure you have experienced that. Isn’t it frustrating? Sure, but it can also turn into an opportunity.
Before deciding how to act, we should try to identify if the false break precludes a real, big break, or indeed a fakeout. Both scenarios provide opportunities.
How to identify a false breakout
A few factors can help determine the move:
- Is the move in line with the larger trend?: Zoom out to the daily or even weekly chart. Is the pair breaking in the same direction as a clearly identifiable break? If so, it has a higher chance of being real. If not, it is probably false.
- Is the break in line with fundamentals?: If the break was a reaction to significant news that works in the same direction, it is probably real. For example, if EUR/USD rises on good news from Europe or bad news from the US, there is a higher chance that the break is real. If the news goes in the other direction or there is no news at all, chances are lower.
- Are trading liquidity and volume high?: If more money is involved in the move, it has a higher chance of being real. The European afternoon / US morning is a time of high liquidity. The time between the US close and the Tokyo open is of low liquidity and that’s when we had the famous “flash crash” of the pound. An event that happens when liquidity is low is bound to fail.
If it looks real
If the answers to the questions above are positive, there is a good chance that the false break was a preparation for a real one. Some stop loss points were triggered but the setback is probably temporary.
In this case, you may get a second chance to trade the breakout, this time riding on a real one. You can enter the trade while the pair is back in the range, not waiting for another move above resistance or below support. So, the risk reward ratio may be even higher thanks to the initial breakout that triggered a setback.
And if you identified the potential for a breakout before the initial, false move and still want to jump in, perhaps consider a wider stop loss in case the initial break is false.
If it looks false
If the answers to the questions above are negative, the false breakout provides an opportunity to go against the direction of the breakout: deeper into the range. So, a false downside break provides a long opportunity while a false upside break provides a short opportunity.
And, if you catch the false breakout in real time, you can go against the break and trade the pair back into the range. This means the simple idea of buying low and selling high or selling high and buying low.
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