FOREX

Instructor Tyler Yell of DailyFX.com shows you how to take advantage of false breakouts that experienced traders love to trade but traps new traders.

You know that the right trend can make your month or year as a trader. Who can blame traders for wanting to hunt for trends? We do not and we certainly recommend you take advantage of clear trends like the EUR/NZD below when trends presents themselves.

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However, as a trader, you must be familiar with how to identify a false breakout over a legitimate breakout. Many traders try and force trend entries when a breakout occurs even though the market has no intention of honoring that breakout. Any trend follower is familiar with the feeling of entering into a bad trade when they prematurely entered into a trade. It feels like a trap.

It’s time that you come to grips and learn how to tell if a breakout is real or if you should fade the breakout and take advantage of the great risk: reward ratios that are available when you notice a false breakout.

Here are the tools we’ll use to protect ourselves against getting trapped into a false breakout.

  • Average True Range (14 periods)
  • Support & Resistance
  • Candlestick Analysis

Here’s what it will look like on your screen:

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Average True Range (ATR)
The average true range indicator allows you to see the volatility behind the pair you’re trading by measuring daily moves. You can use ATR to test the validity of a breakout when price pierces support or resistance. The reason we use the ATR is to determine the amount of pips the range must be broken by before we enter into the trend or decide to fade the breakout. As an example, the ATR (14) for AUD/USD is 68.0 pips as of today’s reading. The ATR (14) for GBPJPY is 114.6 pips. This tells you that the GBPJPY is 2X more volatile in pip terms than AUDUSD. We would look for a breakout from a range above 68 pips and 114.6 pips respectively before we enter with the new trend. If this doesn’t occur we look to take a high probability trade back into the newly expanded range with a strong money management system.

Rule one of trading false breakouts is that if price doesn’t break the range by the ATR, the breakout is false and we should fade the overextended move. If the pair pushes through by more than the ATR then we are looking at a legitimate trend to follow that should now be on our watch list.

NEXT PAGE: Two More Tools for Trading False Breakouts

Tickers Mentioned: EUR-NZD