Trading the breakout is one of the most successful trading strategies used by many traders. Still, many chart formations show a number of false breakouts before a real breakout will occur. Being able to distinguish these false breakouts from real breakouts and not waste money on lost trades with false breakouts is an essential skill for any trader looking to trade breakouts.
This article will tell you how to do that.
What is a breakout?
Many chart formations such as continuation patterns, reversal patterns, or support and resistance levels feature a price level at which prices are expected to behave in a certain way. With trend lines, for example, approaching prices are expected to turn around.
If they do not do that, however, the market will end the chart pattern. Therefore, many traders have to liquidate their current positions and open position in the opposite direction. This will cause the price to break through the chart formation with a lot of momentum.
Determining when this breakout will happen, however, is not always easy. Chart patterns are not an exact science and sometimes the market will move past a price level where a breakout should happen just to turn around again and continue the original pattern. These false breakouts can cost a trader a lot of money.
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How to determine a false breakout
To tell a true breakout from a false breakout, your first instrument is to focus on closing prices of periods instead of highs and lows. Highs and lows often are random movements that should not be taken too seriously. The close, however, is more realistic indication of market sentiment.
Many false breakouts are breakouts of the highs or lows of a period, while the closing price has already moved back into the chart pattern. Therefore, the first step to eliminating false breakouts is to only react on market movements when the closing price confirms the indication given by the high or low.
Another indicator of a true breakout is a surge in volume. Since a true breakout involves many traders liquidating their old positions and opening new positions, a breakout should be accompanied by a sudden spike in volume. If this spike has not yet happened, the market has not yet broken out of the formation.
If you are looking for a secure trading sign and can live with the delay in generating the signal, you should wait for the volume to confirm the breakout before you invest in a binary option. Of course, the later signal makes trading a touch option harder, and you should stick to more basic trading forms such as High / Low options.
Another great method to discover false breakouts is to combine the breakout trading with another technical indicator such as the momentum indicator or the relative strength index. These indicators can provide you with an indication of whether the movement is weakening or still strong. You can use this information to predict whether it has the strength to generate a true breakout or the weakness to generate a false breakout.
As a final option, candlestick formations can help you discover false breakouts. Often, you can find candlestick formations that indicate a turnaround near trend lines, support / resistance levels, or other chart formations. If you find these formations, you know that a turnaround is very likely and a breakout is very unlikely. If the market still moves above or below the price level, you know this is almost certainly only a false breakout that you should not invest in.