01 What are breakouts and fakeouts?

A breakout is when the price of an asset breaks out of a support or resistance level with increased trading volume, indicating a change in supply and demand and a potential starting point of a strong move.

Breakouts can be popular with many technical traders as they typically present potential trading opportunities.

However, the market will often give fake signals.

When the price breaks a support or resistance level but then fails to hold it, a potential breakout can turn out to be a false breakout, which is also referred to as a fakeout.

Breakouts are commonly seen in the financial market. However, fakeouts can appear more often than breakouts, and traders may get hurt by a fakeout as it might produce a significant move against the anticipated trend.

Accurately distinguishing a genuine breakout from a fakeout is crucial, as it could lead to improved trading outcomes.

02 Two types of breakouts

Traders can use multiple technical methods, such as price patterns, trend lines, and moving averages, to look for potential breakouts.

There are two types of breakouts: continuation breakouts and reversal breakouts.

A continuation breakout typically occurs after the completion of consolidation in a trend, signaling a potential continuation of the prior trend.

A reversal breakout appears after the exhaustion of a trend, indicating a potential price reversal.

Knowing what type of breakout is likely to happen can help traders better identify the potential market direction.

Reversal breakouts often take a longer time to build momentum. On the other hand, continuation breakouts tend to occur more rapidly.

Continuation price patterns include flags, triangles, and rectangles, and reversal price patterns include head and shoulders, double tops, double downs, and diamonds.

03 How to identify a breakout from a fakeout?

Identifying a potential breakout from a fakeout can be tricky. Traders often look for some key signals before making decisions.

• Volume

Breaks on high or increasing volume are likely to be real breakouts, while breaks on low or decreasing volume tend to be fakeouts.

This is because heavy volume indicates that more traders are acting in the direction of the move, and the move is likely to be sustained.

On the other hand, low volume means that there are fewer market participants, and the move can be more prone to fail.

• Degree of penetration

The greater the market’s movement beyond a resistance or beneath a support level, the more likely it is to signal a stronger breakout.

Some traders would use a percentage-based criterion to judge the validity of a breakout through a potential support or resistance level.

For instance, a penetration of 3% beyond a major support or resistance level might be necessary to validate a breakout, meaning the closing price must move at least 3% past that level. For shorter-term support or resistance levels, a smaller threshold, such as 1%, might be sufficient to confirm a breakout.

It’s worth noting that the violation of a trend line does not necessarily mean a trend reversal. It may simply signal a change in trend in a certain period.

• Volatility

If the price moves quickly toward a potential support or resistance level, traders may argue that a breakout is on the way.

However, if the price is inching like a caterpillar toward that level, it’s more likely to see a fakeout.

Volatility measures the speed of price changes. High volatility occurs when the price makes a large movement within a short time, indicating a substantial change in supply and demand and a potential starting point of a strong move.

Traders can keep an eye on price gaps and some volatility indicators to track market volatility.

• Multiple time frames

Traders can use multiple time frames to potentially get more details of the price action.

For example, a potential breakout signal on the daily chart might be considered a fakeout on an hourly chart.

• Potential confirmation

If there are no compelling signals to tell a breakout from a fakeout, traders may wait for potential confirmation.

For instance, the price closes above a resistance level and stays there for some time. This might indicate that the price tries to build momentum before breaking out.

Waiting for potential confirmation may reduce the risk of entering the market prematurely. However, it could also mean lagging behind the market as the price might move further away from the breakout level.

This presentation discusses technical analysis, other approaches, including fundamental analysis, may offer very different views. The examples provided are for illustrative purposes only and are not intended to be reflective of the results you can expect to achieve.

All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.