Identifying Breakouts and False Breakouts

Breakout Traders.

After years of reviewing investing blogs, and sharing experiences and trading styles in chats with other traders, I'm sure that (one of) the most popular are the "breakout traders". This is a type of trader who uses technical analysis to identify high conviction breakout patterns that can profit on bullish rallies or bearish downtrends. They use mainly Price Action Analysis with candlesticks, few technical indicators, and price patterns (trendlines, channels, flags, wedges, head & shoulders, etc) to find breakouts that happen at support and resistance levels.

All traders (day, swings, position) are exposed to a false breakout or a whipsaw. Markets have many false breakouts below support and above resistance, every day, with prices returning into their previous "range zone" after a brief violation. Whipsaws happens when a sharp price movement is quickly followed by a sharp reversal, all inside a common support or resistance lines. Just after the probable breakout, we could identify another "range zone", a zone of conflicting interests where price oscillates between two boundaries.

Here we identify four breakout traders styles:
1- Those who want the breakout to occur and make decisions in that direction.
2- Other expecting the range zone to continue, fading the breakout.
3- Aggressive traders, who trigger the breakout only to drive the price back to the range zone.
4- Finally, are those contrarian traders who are waiting for the momentum to wane and immediately trade back in the other direction.

Here I'm going to focus on the first type, so is key recognize a real from a false breakout, and in the last, how to capitalize on a false breakout using the range zone and price action.

Recognizing a Successful Breakout

Breakouts occur in zones of conflict. Both sides of the market are very passionate at these turning points, but no one knows how much force is required to carry the stock into a sustainable trend. Trade carefully a breakout: price may carry successfully to higher levels, or generate a whipsaw, or just do a false move and start trending in the opposite direction. Risk management is the key to avoid great losses in your portfolio.

Breakouts happen every day, but the more powerful and trustworthy were the ones that occur in three phases clearly defined, involving just Price Action and volume:

1. Action: Price breaks through a resistance (or support) on increased volume. Many inexperienced traders think this move is enough for a sure breakout. Many times it's correct, sometimes could happen the contrary.

2. Reaction: As price expands some ticks, then the buying interest fades, market sell-off and create a pullback. Fresh buyers see the breakout level as the logical point to place their trades. The main characteristic of this reaction phase is decreasing volume. 

3. Resolution: A new rally begins when it touches the breakout level, with price above the Action phase high. New buyers need to jump in to ensure this resolution phase. If the volume fails this scheme of three phases, false breakouts and whipsaws are generated.

Above, in this daily chart of UNH, you can see how powerful the $ 125.50 resistance was: three times could not be overcome between July and November 2016. Only in March 2017 was it able to overcome the level, producing the Action, the first phase of the breakout, with an increase of volume. The Reaction phase is decisive to know which direction the stock will take. It lasted two weeks, after which the price returns to the level of resistance, where the bulls press upwards to complete the Resolution stage with increasing volume. Finally, the stock reach up to $170 level in December (not seen in the chart), confirming the power of a breakout when it meets all three phases. Just a clear resistance line, Price Action, and volume, with no technical indicators.

A simple rule: avoid whipsaws

The feared whipsaws, the nightmare of all swing traders, emerge when the reaction phase of a breakout, mentioned above, failed. The size of the drop depends on how powerful are the forces that pull prices back to the resistance level, versus how many bulls try to support the market. These two forces decide the price behavior: sometimes the whipsaw fades out and a successful breakout begins immediately. In that instant, the loss of volatility gives a good buying signal. 

A typical whipsaw pattern is shown in this GPC daily chart, above:

After the breakout (1) at $45.50, the price is indecisive of the course to take for near two months (2). Just check the candles after the big momentum breakout one in mid-October: multiple rejection candles (pin-bars of different colors) showing the price indecision. Finally, the price decides an upside movement in (3). Those two months were a very difficult place to enter a swing trade. Usually, these whipsaws generate high volatility in the stock, and there is no-rule to manage any strategy there. The best decision is simple: avoid the stock earlier and check other securities.

Taking advantage of False Breakouts: the "Stop Hunting"

Best than avoid the false breakout, the idea for a trader is to recognize when it happens, and take advantage of this. Alexander Elder, in his book "Coming into my Trading Room", consider that some of the best trading opportunities occur after false breakouts, up or downside. The patterns are similar to tails, only tails have a single wide bar, whereas false breakout can have several bars, none of them especially tall. The rules are easy:

- When the price falls back into the range zone after a false upside breakout, you have extra confidence to trade short. Use the top of the false breakout as your stop-loss point.

- Once price rally back into the range zone after a false downside breakout, you have extra confidence to trade long. Use the bottom of that false breakout as your stop-loss point.

He explains the dynamics of a false breakout: "after price hits a resistance, the professional traders (the ones who holds your orders) know there are many buy orders above the resistance level, generally of traders looking to buy a new breakout, and others are protective stops of the short-sellers. .A false breakout occurs when pros "organize a fishing expedition" to run stops For example, when a stock is slightly below its resistance at 60, the floor may start loading up on longs near 58.85. As sellers pullback, the market roars above 60, activating the buy stops. The floor starts selling into that rush, unloading longs as prices touch 60.50. When they see that public buy orders are drying up, they sell short with confidence and prices tank below 60." This pro price manipulation is known as stop hunting, and happens every day at every timeframe. 

In November 2019, KO reached a peak at $47.50, then attacked that level in January and rallied above $48.50, only to sink below the old peak a few days later. The false upside breakout (in the yellow circle) marked the end of its bull market. Back experiences said you can short with confidence in $47 level with a stop-loss in $47.50 for a profitable trade.