Are fake breakouts common?

A lot of traders trade break out strategies. In fact the most profitable traders historically have been break out traders where they are able to take the trade and write the trend. There are many ways to start trading a break out strategy. The most common one is to take the trade based on resistance and support break out. When the resistance is broken with high volume traders can go for long opportunity and when the support is broken with high volume trade has go for shorting opportunity. However not everything is rosy. A lot of times even after all the indicators are aligned with breakout, there can be a fake breakout. And these fake breakouts hurt the most. But what if you cannot only find the fake brakeout but also trade using options?

What Is a Fake Breakout?

A fake break out is as the name suggest a record which is not following through. That means that important support and resistance on his broken however that stock does not follow through and comes back into the previous trading zone. Here is how a fake breakout looks like

Here is the chart of ONGC on 5 min timeframe. As we can see there was a very strong resistance which was created in ONGC from 4th February till 10th February. The resistance level was approximately Rs 271. There was a clear break out on 10 February at around 3:00 p.m. Important thing to note here is that during the same time the volume had increase substantially. A lot of traders who trade bake out would have taken this opportunity and gone for long traits. However as we can see the next day itself the first candle was the big red candle going down by almost 2% and hence the traders were trapped in the fake breakout trade.

Why Fake Breakouts Happen

Let us try to understand why the fake breakouts happen. Smart money and big institution traders are constantly searching for liquidity. Some of the important levels where they get good liquidity are important zones such as previous day high, previous day low, round numbers and other support resistance zones. Price sometimes moves slightly beyond these levels to trigger stop orders and attract breakout traders. Once enough orders are triggered, price reverses because genuine follow-through demand is not present. This leads to a fake out trade.

Also, a lot of times the fake breakouts happen range-bound markets, low conviction environments and on days with mixed news flow.

Identifying a Potential Trap Setup

The important question is how to spot a fake break out. The quick answer is that it is not very easy however there are some ideas that can help to spot of fake break out. The first is that usually the fake break out reverses quickly, within 1-2 candles. The volume also begins to dry up. The candles might not be full body it candles and my look more like pin bar candles. These clues indicate lack of commitment from market participants. Trap-based trading focuses on observing behavior rather than predicting direction.

Structuring Option Trades Around Fake Breakouts

Fake breakouts can actually be used to make profits. The traders can wait for the trade rather than reacting immediately to break out levels. This means that if there is a break out the trader will go for a reverse entry. However, if there is no break out and the Breakout was real then they will be no trade and hence the trader will miss out on the trade.

Option buying can be a good idea while doing fake break out trading. The reason is that a lot of times the rivers and happens very quickly which gives Momentum which is very profitable during option buying.

The entry can be done on the low of the candle which is just before the breakout. The stoploss is the breakout level. The target can be 1:3 or 1:4 in option buying. Lets take an example

Here is the example of Nifty on 5 min timeframe. Again there was a clear resistance zone, which had a fake breakout. The downward trade could have been taken at the low of the green candle.

Option buyers could have bought the ATM put option as soon as the low of the green candle was broken. As can be seen in this example there was strong move on the downside and the put options would have given good profits.

Why Trap-Based Trades Can Offer Favorable Risk-Reward

Fake breakouts not only offer high risk to reward; they have high accuracy as well. The reason is that fake break out often provide logical invalidation levels. For example, if the price has broken out of the range but the breakout is fake that means that the resistance is still strong which will act further as well. So the resistance level becomes a very logical stoploss zone. Moreover, since the price has a lot of room on the downside to reach the support zone the risk to reward is extremely good.

Summary

Breakout trading is very popular and extremely profitable as well. However, not all breakouts are real. A lot of times fake break outs happen which can lead to big losses. But the traders can smartly create fake Breakout trading strategies using options and can take benefit of good risk to reward. Consistency improves when trades are based on behavior rather than anticipation. Understanding traps helps traders avoid becoming trapped themselves.

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