Breakout vs fake breakout: What’s the difference?
Breakout trading and fake breakout trading refer to two different trading strategies in the stock market.
Breakout trading is when a stock price breaks out of a certain range and continues moving higher, whereas fake breakout trading refers to a stock price that breaks out of a range but then falls back below the level it broke out from.
Both breakout trading and fake breakout trading can be profitable, but they have their own risks and rewards.
In this blog post, we’ll explain the difference between breakout trading and fake breakout trading, highlight some common reasons why false breakouts happen, and offer tips on how to avoid them.
Breakout
Breakout trading is a strategy that is used to buy stocks that are about to experience a significant increase in value.
This trading strategy is risky, but the potential rewards are high if it works out.
To make sure breakout trading works well for you, practice with simulated accounts first.
Remember that there is always risk when investing in any stock – never invest more than you’re willing to lose!
Pros and cons
Pros of Breakout Trading:
- Profit Potential: Breakout trading aims to capture significant price movements, offering the potential for substantial profits during trend developments.
- Volatility Utilization: Breakouts often occur during periods of increased volatility, providing opportunities for traders to capitalize on price fluctuations.
- Clear Signals: Breakouts are characterized by clear and identifiable price levels, making it relatively straightforward for traders to set entry and exit points.
- Trend Recognition: Successful breakout trading can help traders identify and participate in emerging trends early on, maximizing potential gains.
Cons of Breakout Trading:
- False Breakouts: Markets can be unpredictable, leading to false breakouts where prices briefly move beyond a level before reverting, resulting in losses for traders.
- Whipsawing: Breakout strategies can be susceptible to whipsawing, where prices rapidly move back and forth, triggering stop-loss orders and causing losses.
- Risk of Overtrading: Traders might be tempted to enter multiple trades in quick succession, leading to overtrading and increased exposure to market risks.
- Market Noise: Breakout signals may sometimes be influenced by market noise, making it challenging to distinguish genuine breakouts from temporary fluctuations.
It’s crucial for traders to carefully manage risk, use proper risk-reward ratios, and incorporate additional analysis to enhance the effectiveness of breakout trading strategies.
Types of breakouts
Horizontal breakouts where an asset’s price breaks out of the support or resistance levels.
Support breakout occurs when an asset’s price surpasses a key support level, often signaling a potential upward trend.
Resistance breakout happens when an asset’s price surpasses a significant resistance level, indicating potential for further upward movement.
Pattern breakouts happen when the price crosses the high or low of the pattern. Examples include channel breakout, triangle breakout etc.
Other breakouts include continuation breakouts where the price moves in a trend, consolidates for a while, and then breaks out and continues the trend. Gap breakouts are breakouts happening after a gap in the asset’s price.
Breakouts include not only prices, but also volume, volatility etc.
Strong breakouts
Breakouts can be identified as a strong breakout only when they are accompanied by one or more of the following:
Technical indicators like MACD, RSI, Moving averages etc.
Market sentiment like news, events, volume, volatality etc.
Fundamental signals can also be useful for longer time frames.
Fakeouts
In trading, a fakeout refers to a deceptive market move that appears to be a significant breakout or breakdown but turns out to be a false signal.
Traders may interpret the price movement as a genuine trend reversal or continuation, leading them to enter positions based on the apparent breakout.
However, the market subsequently reverses, causing those positions to incur losses.
Fakeouts can occur for various reasons, including market manipulation, sudden news events, stop loss hunts or temporary shifts in trader sentiment.
They are particularly common around key support or resistance levels, where traders are closely watching for potential breakout signals.
Successfully navigating fakeouts requires traders to use additional technical analysis, confirmatory indicators, and risk management strategies to minimize the impact of false signals on their trading decisions.
Pros and cons
Pros of Fakeouts:
- Contrarian Opportunities: Skilled traders can capitalize on fakeouts by taking contrarian positions, profiting from the reversal when the market corrects itself.
- Enhanced Risk Management: Recognizing and avoiding potential fakeouts can contribute to more effective risk management, preventing unnecessary losses.
- Increased Market Awareness: Dealing with fakeouts enhances a trader’s understanding of market dynamics and helps refine their ability to distinguish genuine signals from false ones.
Cons of Fakeouts:
- Losses from Misjudgment: Failing to accurately identify a fakeout can result in significant losses, as traders might enter positions based on false signals.
- Psychological Impact: Experiencing fakeouts can impact a trader’s confidence and decision-making, potentially leading to hesitation or reluctance to enter new positions.
- Challenging to Predict: Predicting fakeouts with certainty is difficult, as market conditions and participant behavior can be unpredictable.
- Increased Transaction Costs: Frequent fakeouts may lead to increased trading activity, resulting in higher transaction costs for traders.
Understanding the market context, using additional indicators, and having a disciplined approach to risk management are essential when dealing with the challenges posed by fakeouts.
Avoid fakeouts
To avoid fakeouts as a breakout trader, consider these tips.
The most crucial one is to wait for the breakout and enter after confirmation.
If you prefer a more conservative approach, wait for a pullback to form after the breakout before entering the trade.
Utilizing ATR for stop loss can help mitigate fakeouts.
Confirming with higher timeframes to ensure alignment with the current trend is another strategy.
Additionally, incorporating volume, news, and events can provide further confirmation.
My experience
When I began trading, I used to exit randomly whenever I felt fear or greed. I would enter at a breakout, exit at a reversal, thinking it was a fakeout, and then re-enter when it reversed again. It was such a mess.
However, since I came to understand the strategy I am using today, I am very clear about breakouts, and there is no worry about fakeouts.
I mainly use 1*ATR as a stop loss from the breakout level. It has almost never hit the ATR stop loss level if it was a genuine breakout.
Conclusion
Breakout trading is a highly profitable strategy that can be used by investors to make money in the market. Breakout trading is when a trader identifies a stock that is about to break out of a price range and take the price up significantly. Fake breakout trading, on the other hand, is when a trader identifies a stock that is about to breakout but does not actually break out of the price range. False breakout trading can be dangerous because it can result in the trader losing money. to find breakout or fake out, you need to have a good understanding of price action and technical analysis. Make sure to follow these tips to avoid false breakout trading and make your trading career a breakout success!
About Post Author
Resources & Links
Tradingview – Charting Platform
Zerodha – Trading brokerage platform (India)
Disclaimer
Trading involves substantial risk, and past performance is not indicative of future results. Always conduct your own research and consider seeking professional advice before making any investment decisions. The information provided on this platform about digital entrepreneurship is based on the author’s experiences and industry knowledge. It should not be considered as financial, legal, or business advice. Please consult with experts in these fields before making business decisions. This blog may contain affiliate links, and we may earn a commission if you make a purchase through these links. Your support is appreciated.
