How to Avoid False Breakouts – and trade the good ones (the secret is one simple rule)
We all have traded a false breakouts, haven’t we? OK, not all, but most of us have.
If you are one of the few traders who still haven’t, you should do it at least once hehehe… just to get more experience (I’m kidding, even if you wanted, you never know what kind of surprises the market has for you).
Anyway, this is how it feels to trade a false Breakout
You draw an important resistance level (at least you think it is important)… you feel confident about this level and decide to set a buy stop order just above the resistance level.
What are your thoughts at this moment?
You cant wait to see the market triggering your order, because you know once it reaches the level, the market will explode, and you’ll get at least 50 pips in a few minutes, piece of cake (you close your eyes and picture this scenario).
You stay away from the chart for a few minutes, and once you see the market trading below your buy stop order, you switch over to a lower timeframe (as if it would give you control over what the market is doing). There you are, starting at the 1 min chart without blinking… and of course, a big smile on your face…
Everything looks good…
You are still positive about this trade, you review everything, you confirm every aspect of the plan and you arrive to the same conclusion: This is the trade of the week.
The market triggers your order. You start to get really nervous (some say they could actually hear they hearts bit – ? ). But then something happens…
The market completely stalls at your entry price.
Then, without prior notice, the market starts to fall back down and stops you out. You didn’t even see your trade at the BE level… And you go like:
At least to me, it does :)
Ok, so here is a good question:
Should we avoid trading breakouts?
I dont think so.
In fact, I think breakouts are one of the most underused strategies with lots of potential. We’ll talk about this in a minute.
I’ve even heard of traders using a strategy to trade against breakouts, and to be honest, I don’t think it is a wise thing to do.
Let me show you why.
We have this type of breakout that are not good for us:
But we cant forget about trading breakouts because we would forget about this type of breakouts too (the ones that actually work, and you know they are like diamonds to us):
And the million dollar question is:
How do I know what type of breakout I’m trading?
We’ll never know with a 100% accuracy, but I’ve got a methodology that helps me determine which breakouts have a higher chance to follow through… still with me?
Ok so here we go.
It’s all about the Market Condition
You have no idea how the market condition could help you trade better.
Last week I talked about how I’m going to approach fundamental announcements this year: I’m not taking them in consideration anymore, because most of the time, the reaction of the market to these announcements is in the direction of the market condition.
The same goes for the breakouts.
- If I have a bullish market condition: I’ll only take long breakouts
- If I have a bearish market condition: I’ll only take short breakouts
- If the market condition is not clear: I’ll not trade any kind of breakout
I talk vastly about the market condition (and how to do it) in my article: how to perform a good analysis.
Forget about going long, short, then short again, then again long in the same currency pair. It’s not about trying to capture every single market movement, it’s about knowing what the market is likely to do, then trade accordingly.
It sounds very simple, yet is very difficult to accomplish.
You need experience, and need to be humble, when you are wrong, you are wrong, that’s it. Arguing with the market it’s not worth it. Lost one trade, ok, good. Move one to the other chart and try to forget about this one.
How to trade breakouts
Ok, so here is a simple methodology to trade breakouts:
1 – Support and resistance levels
You need to make sure you are drawing the right support and resistance levels, forget about Fibo levels, povots, etc. The best support and resistance levels are manually drawn.
2 – Take breakouts only in the direction of the market condition
If the market is likely to continue it’s way up, only take breakouts to go long. Forget about shorts (and stop trying to guess every market movements, it’s impossible to do). And the same then the market is likely to continue it’s way down, only take breakouts to go shorts.
So make sure you do your analysis before starting to trade.
3 – Always use tight stop losses
The reason I like breakouts it’s because of the risk reward ratio you get when you trade them. Once the market breaks an important level, it should stay above the same level, if for any circumstances the market falls back down, just close your trade (the reason that made you go long is no longer present).
Forget about it, move one and try to look for trade opportunities elsewhere.
4 – Take profit orders vary depending on your trading style
Based on the way the market has been trading lately, I take partial profits, to take advantage of the short term swings, but also hold the remaining half to take advantage of the medium term market swings.
This is what I do, you need to adjust this based on your trading style.
Do you trade breakouts? If you do, What do you think about this methodology?
If you don’t trade them, please comment and tell me why.
If you know someone who would benefit from this article feel free to share it.
I’ll appreciate it!