The breakout is one of the most significant events in trading. It indicates the completion of a price formation, and the beginning of a new market phase. Binary options traders can benefit from the breakout by trading it directly, and by using it to make accurate predictions about the market’s future.
In terms of channel analysis, a breakout usually means the trend is over, and the channel has lost its relevance. Most of the time, this changes the market’s entire behavior: Rate of change, volume, momentum, and times in which swings occur – usually, none of these fundamental indications of market behavior remain the same.
This applies to every true breakout. Unfortunately, not every breakout is true.
What is a true channel breakout?
True breakouts are the result of an honest change in market sentiment. For a true long breakout, a significant part of traders in the market has to switch from bearish to bullish. For a true short breakout, on the other hand, a significant part of traders in the market has to switch from bullish to bearish.
Sometimes, however, the market will escape the channel’s lines by mere coincidence. There is no general answer to why these false breakouts happen. Often they are the result of meaningless events that no have implication towards the future. Maybe, one trader started buying near the upper channel line because he did not recognize the line. That scared another trader into thinking the channel might be over, so he started buying. That scared another trader, and so on.
These events can make the market stray from its path briefly. They lack, however, the power to create a new trend or end current one. Therefore, they will briefly push the market outside the channel, before it will move back into the channel and resume its original path.
For a binary options trader, recognizing false breakouts is essential to success. Jumping on a false breakout will almost always result in a lost investment. Over time, false breakouts can reduce a trader’s winning percentage significantly, and, if a trader invests in too many false breakouts, easily cause the trader to lose a lot of money.
Therefore, every binary options trader has to be able to distinguish false and true channel breakouts from each other. For some traders, this is especially problematic. They are confused which breakouts are real and which are false, and always seem to be one step behind the market.
To avoid these problems, there are four simple rules you can use to determine a false breakout from a true breakout:
1) Watch the volume
As with any market movement, the higher the volume, the more significant is the movement. This applies to channel breakouts, too: A channel breakout that is accompanied by a high trading volume indicates that many traders share the change of market sentiment the breakout indicates. A breakout accompanied by low volume, on the other hand, most likely is the result of just a few traders investing in a direction that they probably should not invest in.
Therefore, the first step to eliminating false breakouts from your trading is not to ignore breakouts with a low volume. Do not trade the breakout directly, and wait a few periods to see if the market confirms the breakouts indication or not.
2) Wait for confirmation
Some traders like to use an even more failure prove approach: They always wait a few bars before they invest in the breakout, even if the breakout had high volume. This approach certainly helps you to eliminate even more false signals.
If you are using breakouts as a general indication of market sentiment, the wait might be well worth it and not even result in any negative effect for you. If you are investing in the breakout directly, on the other hand, waiting a few periods will significantly decrease your winning percentage, because you will likely invest too late. For this kind of strategy, you should invest directly after the breakout occurred.
3) Wait for a certain size
Some traders do not verify the breakout by duration, but by size. They argue that, if the market has moved far enough from the channel line to make a drawback unlikely, it does not matter how long it took the market to get there.
4) Combine these approaches
Many traders combine the two last approaches and either wait for the breakout to reach a certain length or to be valid for a certain number of periods. This strategy can help you combine the advantages of both strategies while eliminating its disadvantages.