When a failed break occurs, you are on one of two sides of the trade. The staff at Investopedia explains how you can make sure that you’re on the winning side.
As a trader, you've probably been told that it's best to trade breakouts and breakdowns. Countless chart patterns exist to help you pinpoint exact entries and place effective stops.
Knowledge of these patterns and strategies is commonplace among retail traders. And indeed, the strategies work in most situations—if they didn't, then technical analysis would not work. However, this type of predictable behavior begs the question: why doesn't someone take the other end of the trade? Why wouldn't someone purposely break through the predictable stops, knowing that it would crash the prices?
The truth is that this situation does take place on a regular basis. It's called a failed break, and the resulting signal is often more reliable than the original breakout or breakdown. What constitutes a failed break, and how can you turn a potentially disastrous position into a profitable one?
Anatomy of a Failed Break
To get a better idea of how to trade these failed breaks, let's first take a look at the anatomy of a failed breakout:
- A breakout occurs.
- The breakout fails by dropping below the new support (old resistance).
- As a result, stops of short-term traders are hit at predictable levels.
- Triggering these stops causes the price to drop (similar to the way it drops after a short squeeze, as there is a frantic search for buyers in both cases).
- The drop slows down after stops are hit and covered.
- The drop stops and reverses after the price reaches a new major support level, or a fundamental reason causes a reversal.
These are the key validation points:
- The volume is there to confirm the stops being hit.
- The original chart pattern showing the breakout is accurate.
Trading Failed Breaks
When a failed break occurs, you are on one of two sides. Either you traded the breakout and are looking to exit your position, or you are looking for an entry after a failed breakout occurs.
If you traded the breakout and are caught on the wrong side of the trade, you should try to exit before the price hits the predictable stop-loss levels. This will help you avoid slippage, which can be seen in illiquid stocks when failed breaks occur. Then you can look to re-enter in the opposite direction, assuming that you are sure that the breakout failed (i.e. the movement is not simply market noise).
NEXT PAGE: How to Handle Failed Breaks