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TE07 - Trading Breakouts and Fakeouts

"Breakouts and fakeouts might seem like a fancy terminology. But you might have come across these terms if you have had some basic trading experience. Breakouts and fakeouts are quite popular with day traders. This is because these occur a lot more on the smaller time frame charts than on the longer time frame charts. While trading breakouts posts significant risks, they can be quite rewarding as well. Because traders are always influenced by profits, breakout based trading is quite popular. Before you get into breakout based trading, you should be aware of the risks. A failed breakout is nothing but a fakeout. A fakeout can trap your position to the point that if you do not employ good money management strategy, you could end up with big losses. While there are a number of indicators you can use, breakouts are quite unique to each other. Sometimes they work and most of the times they don’t. Learn what are breakouts and fakeouts and how you can trade them in this article."

Breakouts and fakeouts are two terms that you will come across in technical analysis based trading. Breakouts and fakeouts are basically two sides of the same aspect that you will come across when trading.

In order to understand how to trade breakouts and fakeouts, we must first understand what it is and how are they formed.

We already know that prices don’t move in the same direction for too long. Price moves in different waves as it corrects itself within a trend. Sometimes, you can see that price starts to trade within a range.

Ranging or sideways markets are where prices move flat. In doing so, they establish a range. This is also known as the accumulation phase. After a period of time, price breaks out from this accumulation or the ranging phase.

When the breakout occurs, price tends to move rather rapidly.

Thus, trading breakouts can be quite successful as it helps to improve your profits rather quickly. But it comes with a risk.

While a breakout is defined as where price shoots up or down from the sideways range, a fakeout is one that can lead to losses.

The name fakeout comes from the fact that prices, sometimes will indicate that they are breaking out in one direction only to reverse course and breakout in the other direction.

Fakeouts can trap weak positions as price reversals can be strong. In order to trade breakouts successfully, you should know that fakeouts are part of it. The best way is to avoid fakeouts.

While there is no science to this, it all comes down to risk management and how you position your trades.

How to trade breakouts?

You can trade breakouts be first identifying the trend. Assuming that price is in an uptrend, look for periods where price moves into a ranging direction. This could mean a flat range.

Then, plot the range’s high and low points and wait for the breakout.

If the trend is still young, then there is a high chance that the breakout will be to the upside. But of course, this is not set in stone. You need to have the market context for this.

The chart below gives an example of the previous trend, the ranging markets and the breakout that occurs.

TE07 01 Example Breakout

Example of a breakout

 

In the above chart, you can see the example of a breakout. Here, price moved into a range after a downtrend. Then, price settled into a sideways range. This was followed by an upside breakout.

Eventually, price reversed direction and moved in the opposite direction. This is an example of a successful breakout.

The general rule of thumb is that when there is a breakout, price moves a minimum of the distance it established when it was trading flat. Thus, traders usually enter the trade after the breakout and set the take profit level to the measured level.

Stops are usually placed near the lost pivotal low before price reverses.

How to trade Fakeouts?

A fake out, as you know is when price makes a fake break out. This traps the weak positions. As price continues in the reverse direction, the positions are squeezed to a point that traders end up closing their trades.

This leads to further momentum in the fake breakout.

Below is an example of a fakeout.

TE07 02 Example Fakeout

Example of a Fake out

 

In the above example, you can see how price breaks out of the range rather strongly. This would prompt traders to take a short position.

However, in the very next session, price posts a strong reversal. This leads to price moving back into the range. This is nothing but a fake breakout at work. All the short positions would be left with losing positions.

Thus, when they close the positions, which leads to a buy, the momentum gains further more from these weak positions.

How to avoid Fakeouts?

The most simple rule of thumb is to firstly ascertain that the breakout is valid. There are instances when price often retreats back to the breakout level and tests the breakout. On this second attempt, traders can enter the breakout.

But be warned that this is by no means fool proof. Price could indeed move in the direction of the breakout, but it could also reverse direction mid way. Thus, the most important thing you can do when trading breakouts is to ensure that you do not risk too much of your money.

Breakouts can be fast paced. They are more evident on the smaller time frame charts, which explains why many day traders prefer to trade breakouts. By bearing the simple fact that you should pay attention to your risk management, you can build a fairly profitable breakout trading strategy.

Read 975 times Last modified on Friday, 26 July 2019 17:31

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