Consider the following scenario.
You’ve had EURUSD on your watch list for weeks. More specifically, you’ve been waiting for a break below a key support level to take advantage of the selloff that’s sure to follow.
After three weeks of practicing saint-like patience and unshakable discipline, the Euro finally sells off against the US dollar and closes below support.
The wait is over!
You open your trading platform, enter the necessary details of the trade and place a limit order. Before you go to bed, you work out what the profit will be one last time out of sheer excitement.
The following morning you awake to find that not only did EURUSD fail to respect former support as new resistance, but it also rocketed 200 pips higher against the USD taking out everything in its path including your stop loss.
The pair goes on to close the day back above your key level, negating the entire trade idea as well as your bearish bias.
Sure it does. We’ve all been there. Even the best looking trade setups can and do fail on occasion.
But the million-dollar question is, why did this happen?
Better yet, how could you have mitigated the risk or perhaps even benefited from the false break itself?
That’s what you’re about to learn. By the time you finish reading this lesson, you will have a firm understanding of what false breaks are, why they form as well as how to take advantage of them.
Read on to learn about this little-known trick.
What is a False Breakout?
First things first, before you can learn how to use false breakouts to your advantage, you have to know what they are and how to identify them.
A false break, or breakout, as the name implies, is any move (and subsequent close) above or below resistance or support respectively followed by a reversal that fails to respect the broken level as new support or resistance.
Let’s take a look at an example.
Notice how NZDJPY closed above channel resistance on a 4-hour basis but subsequently failed to hold above it as new support.
What’s important to note here is that we’re dealing with closing prices. If a currency pair merely pierces a critical level, it is not considered a false move.
For example, I see a lot of traders incorrectly labeling the two instances below as false breaks.
Whether you consider these false breaks depends on how you define a “break.” For me, a breakout requires the close of a candle, and because I trade the daily time frame 90% of the time, it often involves a daily close above or below the level in question.
If we revisit the EURGBP chart above, the daily candle merely pierced resistance, so to label this as a false “break” is inaccurate as the candle never actually broke (closed above) the key handle.
Now, if you had been trading the 15-minute chart, the decision about whether or not it’s a false break would have been different. Having said that, the technique I’m about to show you is only accurate when used on the higher time frames such as the 4-hour and daily charts.
There is often too much “noise” on the lower time frames to adequately gauge what is a false break and what is not.
This brings us to the next, very important subject of time frames.
Time Frame Matters
The time frame you use to trade and thus identify these false breakouts is paramount to the overall effectiveness of this strategy.
To explain why this is the case, let’s revisit the EURGBP chart above.
The two instances above were clearly NOT false breaks on the daily chart as well as any time frame above the daily. The pair never actually closed above the critical level; thus we couldn’t consider it a false breakout.
But what about the 4-hour chart?
Let’s take a look.
As you can see, while the daily chart never closed above resistance, the 4-hour chart certainly did.
So was this a false break for those trading the 4-hour chart at the time?
Perhaps, but remember that one of the ingredients for any false break is an obvious level of support or resistance. The retest in the chart above occurred after just one other test of resistance.
With this in mind, attempting to trade or even analyze the price action on a 4-hour closing basis would be ill-advised.
To understand why we have to go back to price action trading 101. One of the tenants of trading between support and resistance is that you must know which time frame is respecting a given level or pattern.
In the case of the EURGBP chart above, the 4-hour had not established itself as the predominant period in relation to the resistance level.
To clarify what I mean by predominant, let’s compare it to the ascending channel that formed on NZDJPY.
Notice how NZDJPY touched both support and resistance on several occasions prior to the false breakout. In this case, the 4-hour chart was clearly respecting the pattern and could therefore be used to assess the implications of the false break that eventually materialized.
Any false break is only as valid (and telling) as the time frame on which it occurs.
So which time frame is “best” for using the technique I’m about to show you?
In my experience, the 4-hour and daily periods work the best. However, each situation is unique, so it all depends on which time frame is respecting the key level in question.
Trading Away From False Breaks
Now that you know how to identify these false moves let’s dive into how you can take advantage of them.
Just like the pin bars we use when trading price action, a breakout that immediately fails is a sign of strength or weakness. We can use this to our advantage just like any other price action signal.
In fact, you can’t have a pin bar on the daily chart without having a false breakout on the intraday charts. The same applies to any combination of time frames.
The NZDJPY 4-hour channel below is a great example. Once the pair closed back below the upper boundary of the structure, it was time to begin watching for selling opportunities.
Note that the pair eventually found a bid right where we’d expect – at the channel support that had attracted buyers on three previous occasions.
In summary, we would have looked to sell on a 4-hour close back below resistance with a target at channel support.
Staying Out of Trouble
Remember how I mentioned that you could have mitigated the risk of getting sucked into these traps at the beginning of this lesson?
The best way to do that is through a firm understanding of price action. And that involves more than just pin bars and inside bars.
Allow me to explain.
You may have noticed that shortly after closing above channel resistance, NZDJPY formed a 4-hour bullish pin bar.
Now, you may be asking yourself, why wouldn’t we have traded that bullish signal, which ultimately failed?
Good question. The reason we didn’t commit to this particular pin bar was quite simple.
The pattern in question is an ascending channel and therefore has bearish implications. As such, we would only want to trade a breakout below channel support, which never materialized before the close above resistance.
Technically speaking, the pattern above was a bearish flag as it was the result of an impulsive move lower. That meant that any buying was counter-trend and thus not advisable.
Pro Tip: As a general rule, ascending patterns have bearish implications while descending patterns have bullish implications.
If on the other hand a pin bar had not formed here and the level was a horizontal pivot rather than a channel, we wouldn’t want to trade the breakout without confirming price action.
What is “confirming price action”, you ask?
Simply put, it’s a bullish or bearish pin bar that forms on a retest of the broken level. It adds conviction to the setup and provides a place to “hide” your stop loss.
You won’t always be able to avoid false breakouts. No technique or strategy will keep you safe 100% of the time.
But through the combined use of technical patterns and bullish or bearish price action, you can give yourself the edge needed to make money over an extended period.