What is a false breakout and how can you avoid it?

What is a false breakout?

A false breakout is a failed breakout – so, before we can unpack one, it’s important to ascertain what a ‘real’ breakout is.

A breakout is a market movement that happens when an asset class (e.g. stocks) breaks out of its normal price range, either the support level or resistance level. When the market price shoots significantly higher or lower than usual, that’s called a breakout.

However, in order for something to truly be considered a breakout, this momentum has to be sustained, and can’t simply be a brief uptick in price. If a stock or another underlying asset rises out of its support or resistance level, only to revert back down again shortly afterwards, this is what’s known as a false breakout.

Find out everything you need to know about breakout stocks

Breakouts vs false breakouts:

How to identify false breakout patterns

It can be tricky to identify when a breakout is genuine and when it’s a ‘failed break’, also known as false breakouts. Fortunately, there are ways to recognise them.

One of the simplest ways to identify a false breakout is to make a note of how long it lasts. Because failed breaks are fleeting, watching your chosen asset for a while is often an effective way to tell if a breakout is genuine or not.

Similarly, you need to have studied your market well, as all of them have histories of false breakouts and true breakouts over time. This can help you recognise where a current break may resemble previous ones that turned out to be false. Just remember that past performance isn’t always an indicator of future results, so let these figures inform you rather than decide for you.

Another crucial step to identify a failed break is technical analysis. This helps you determine what your chosen market’s support and resistance levels are and provides key insights when you try to differentiate between a breakout and a false breakout.

That’s because, generally, a breakout is more likely to be false when it hits the same support or resistance level a number of times, but has always pulled back from this point before. However, the more unusual it is for an underlying asset to break through a certain price range, the more likely it’s driven by true momentum and high volumes – often the sign of a true breakout.

Broadly speaking, there are two main types of false breakout patterns that occur:

• A bull trap: when a market looks set to trend higher than it has before, by breaking out of its upper resistance level. However, the price drops down again, confirming it was a false breakout

• A bear trap: the opposite of a bull trap, where a market drops down lower than its normal support level, but then rallies before it can be a true breakout

How to avoid a false breakout

It can be almost impossible to tell a true breakout from a failed break if you don’t know what you’re doing. Here are four ways to avoid a failed break:

Take it slow

One of the simplest ways to avoid a false breakout is also one of the most challenging for many traders – to simply wait. Instead of buying in to the trend the moment your pair breaks through its support or resistance level, give it a few days (depending, of course, on your trading style and its timeline) and watch as, often, the failed breaks simply weed themselves out.

Watch your candles

A more advanced version of waiting it out, a candlestick chart can come in handy. When you suspect a breakout is happening, wait till the candle closes to confirm its strength. The stronger the breakout appears, the more likely it’s not a failed break.

While this can be an effective way to identify false breakouts, many traders don’t have the time to sit and watch their chosen chart around the clock. That’s why, with us, you can set alerts to notify you of the specific market conditions you’re waiting for. In the case of a breakout, for example, you’d create an alert based on candle’s close price, to notify you of any potential breakouts.

Use multiple timeframe analysis

Another efficient way to identify breakouts, and what of those are likely failed breaks, is multiple timeframe analysis. This entails watching your chosen market using a variety of different timeframes. When using this technique, you’d likely spot the potential for a breakout in the short term, then ‘zoom out’ to view that same market over a week, a month or even longer before opening a position.

This helps with identifying a false breakout because you’re paining perspective of your asset over both the longer and shorter term. Studying its patterns can show if what you think is a breakout is actually significant in the context of that market.

Know the ‘usual suspects’

Some patterns in charts can indicate the likelihood of a false breakout. These include ascending triangles, the head and shoulders pattern and flag formations.

Learning how to identify these patterns can help you to tell the difference between a breakout and a false breakout, as these three formations are often associated with failed breaks. For example, ascending triangles are indicators of a temporary market correction, rather than a true breakout.

How to trade on a false breakout

While it may sound counterintuitive, there are also times when you may want to take a position on false breakouts.

You may want to use a false breakout as an opportunity to go short, making a profit or loss from predicting that a market’s price is about to drop from its current high. Or, you could use it as an opportunity to hedge – going long in case it’s a true breakout and also going short on the same market in case of a failed break.

To trade a false breakout you’d:

1. Create a live CFD trading account
2. Do technical analysis on your chosen market to identify false breakouts
3. Take steps to manage your risk, including stop orders and limit orders
4. Open and monitor your first trade

How to trade breakouts

Here’s how to trade breakouts with us:

1. Create a live account or practise first with a demo account
2. Learn the signs of a market about to break out – you can find out far more about breakouts by upskilling yourself on IG Academy
3. Do technical analysis on your chosen market to identify false breakouts
4. Take steps to manage your risk, including stop orders and limit orders
5. Open and monitor your first trade

Everything you need to know about trading breakout stocks

You’ll use contracts for difference (CFDs) to do this – a financial derivative that enables you to trade. For example, you may want to use a false breakout as an opportunity to go short, making a profit or loss from predicting that a market’s price is about to drop from its current high. Or, you could use it as an opportunity to hedge – going long in case it’s a true breakout and also going short on the same market in case of a failed break.

False breakouts summed up

• A false breakout is a significant movement out of a market’s normal support or resistance levels that doesn’t last – hence it ‘fails’
• These can cause costly mistakes for traders, thinking a market has hit a true breakout and going long, only for it to lose momentum shortly afterwards
• You can avoid false breakouts – or trade them intentionally – by studying your chosen market and knowing the chart patterns, timeframes and other signs of a failed break
• With us, you can trade on breakouts and failed breaks using CFDs