False breakouts occasionally appear on the chart and can create confusion in trading strategies. Perceiving a false breakout as a genuine signal, a trader may act recklessly, leading to mistakes and, ultimately, financial losses due to opening or closing specific positions. That’s why it’s crucial to learn how to distinguish false moves on the chart from genuine price fluctuations that form a certain trend. This can be achieved in two ways: entrusting the most critical trading decisions to automated tools, such as the best MT5 EA , or learning to analyze the chart independently to avoid errors and inaccuracies and prevent financial losses.
Understanding False Breakouts
When the price of an asset breaks beyond a key level of support or resistance, traders may interpret it as a signal that the price will move in that direction. However, by creating the appearance of a breakout, the price changes its course again. Traders who perceived the fake breakout as a genuine signal experience losses.
Factors Contributing to False Breakouts
This phenomenon occurs in the market for various reasons, including market manipulation by large players. Significant traders in the market can create the illusion of a breakout to trigger stop-loss orders or lure traders into positions. Once liquidity is achieved, the market reverses, catching unsuspecting traders on the wrong side of the trade.
Sometimes, unexpected news releases lead to fake breakouts, provoking initial price movements that seem like breakouts. A genuine breakout is often accompanied by a strong impulse and increased trading volumes. On the other hand, false breakouts may lack a sustained impulse, leading to a rapid price reversal after surpassing a key level. Trading volume during a fake breakout is also diminished.
The authenticity of a breakout can (and should) be confirmed using various analysis tools. These include three candlestick patterns, Bollinger Bands, stochastic oscillators, and moving averages. If there are significant divergences between the signals of these indicators, it may indicate the falseness of the breakout.
Techniques for Identifying False Breakouts
The only answer to the question of how to avoid false breakouts is to learn to identify these signals and operate in the market in a way that these misleading indicators don’t deceive you. To achieve this result, you can practice this skill until it becomes automatic. Make it a habit to cross-check signals from one indicator with those from another. For example, if moving averages suggest a genuine breakout, but you also see a fake breakout candle on the chart, this contradiction may signal that the information should be double-checked before opening buying or selling positions in assets.
How to avoid false breakouts by revealing and identifying them?
- Analyze the strength of price movement: If you notice a breakout signal, but the volume decreases or remains the same, the breakout is likely false.
- Verify information with MACD, RSI, Bollinger Bands signals: Be cautious if there is a lack of clear confirmation or a significant divergence between these indicators.
- Use patterns for additional information: Candlesticks, triangles, flags – these patterns are created to help you see where a real breakout occurred and where the price is likely to return to its previous value.
- False breakouts often occur when prices briefly break through support and resistance levels before reversing.
The best solution to identify false breakouts is to wait for clear confirmation. Enter into buying or selling deals only when you are confident in your actions and have verified that the price movement is stable.
Risk Management Strategies
Perceiving a false breakout as genuine, a trader risks significant capital on unsuccessful deals. Therefore, it’s crucial to not only learn to identify false signals on charts but also protect your assets using risk management tools. Key risk minimizers include stop-loss and take-profit levels, which help you secure profits or prevent losses beyond what you can afford. The higher the market volatility, the wider your stop-loss and take-profit levels may need to be.
When unsure about the strength and accuracy of the signal, adapting position sizes according to the situation is also a wise decision. For example, during periods of market uncertainty, high volatility, or when trading around potential breakout points, it’s better to place positions with smaller volumes. This allows you to avoid serious losses if the signal turns out to be false.
Risk reduction is also facilitated by asset diversification and hedging. Options provide a flexible tool for hedging against potential losses in case false signals are perceived as real.
Common Pitfalls to Avoid
Pitfalls are mistakes that you can make in the trading process by perceiving false signals as true. The most common errors include:
- Inability to wait for confirmation signals before entering a trade;
- Excessive reliance on technical analysis without considering broader market fundamentals;
- Ignoring market depth and liquidity conditions;
- Underestimating the impact of news releases or events on market dynamics;
- Ignoring market depth and liquidity conditions.
Arm yourself with calmness and patience, avoid impulsive actions, and verify technical analysis signals with the data provided by fundamental analysis. Consider how genuine the breakout you see in the forecast can be, taking into account the deeper trading context: volume, volatility, geopolitical events, etc. This allows you to act cautiously and thoughtfully, avoiding mistakes and financial losses.
Summary
Breakout signals, which are actually short-term price fluctuations, can bring a lot of trouble to a trader. Make it a habit to cross-check information using multiple indicators, act cautiously, diversify assets, and manage risks, especially during periods of high volatility caused by ambiguous news and political or economic shocks. Remember that strong players always try to sway the market one way or another, but these sentiments may not have sufficient strength. Knowing all these nuances and being able to distinguish false signals from real ones clearly, you can trade successfully and easily, buying and selling precisely when it is most advantageous for your trading portfolio.
About the Author/s
The New Jersey Digest is a new jersey magazine that has chronicled daily life in the Garden State for over 10 years.
