How to identify fake breakouts and breakdowns?

Even if we have studied numerous candlestick patterns and chart patterns, and seen them being formed in live market, we still often get bamboozled by the price action, and end up clocking losses. Why do these patterns fail so often?

Are we missing something?

As they say – “Half knowledge is more dangerous than no knowledge.” Even after you acquire all the theoretical knowledge on technical analysis of share market charts, we will still be lacking on some vital info, which only experience can teach us. Just like English Grammar, there are exceptions to almost all rules and patterns in technical analysis. That’s why experts always use stop loss, and insist on double confirmation before we enter any trade.

In this article, we will discuss some of the tips and tricks to identify false breakouts and breakdowns. Though with time our own experience will teach us a lot more, it’s a good idea to learn from others’ experiences to give ourselves a headstart.

Note

Smart people learn from their own experiences.
Fools do not learn even from their own experiences.
Geniuses learn from even other people’s experiences.

Table of Contents

What are fake breakouts and breakdowns?
Why do false breakouts and breakdowns happen?
How to identify fake breakouts and breakdowns?

What are fake breakouts and breakdowns?

Idea behind studying and analysing various chart patterns and candlestick patterns is to get an idea of the forthcoming price action. That is, how the price will react once that particular pattern ends. Will the price move up rapidly and give us a nice breakout, or will the price move down out of a sudden and we will get to see a breakdown.

However, accuracy of these patterns is not 100%. Some patterns work better than others though, but none is perfect.

Sometimes, a pattern predicts that a breakout or breakdown will come, and we do see that happening. This pulls in many retail traders to enter the trade. However, soon they see that the breakout/breakdown is not sustaining itself. The price reverses and hits their stop loss (called stop loss hunting).

This is what we call fake breakouts/breakdowns. And this is one of the most significant reasons behind many retail traders booking losses on a regular basis. If we can learn to identify these fake breakouts/breakdowns, we can avoid a lot of losses.

But before we do so, let’s understand why these false breakouts/breakdowns happen so often.

Why do false breakouts and breakdowns happen?

To understand the reason behind false (or fake) breakouts and breakdowns, we first need to understand that there are four major types of traders trading on the share market (or any market for that matter, be it forex, currency, cryptocurrency, etc.).

Retail traders: these are the small traders – small fishes in the sea. Most of us fall in this category.
Institutional traders: Mutual funds, insurance companies (LIC, and others), etc.
Foreign Institutional Investors (FIIs)
Propriety Accounts (Pro)

The retail traders are the weakest ones, as in general they have lack of knowledge, and lack of resources (time, software, team, data, etc.). For example, most retail investors have no access to the third-level data. And share market is a platform where the smarter party and the one with more resources makes money at the expense of the weak ones.

The big players of share market (i.e. big bulls, operators) often try to play smart game with small retail players. Their strategy is simple:

Dangle a carrot: Make a fake breakout/breakdown on the chart, so that retail investors may put in their money.
Stop-Loss Hunting: After some time, reverse the trend. Their aim is to move in opposite direction as fast as possible – this gives no time to retail investors to react and their stop loss is hit, and so they book losses.
Now, the big bulls of the market make huge profits.

If we can identify these false breakouts/breakdowns, and enter the trade at the right time, we can make huge profits. That’s because after these breakouts/breakdowns, we often see fast and huge price action.

But how?

How to identify fake breakouts and breakdowns?

We can use various tricks to identify fake breakouts and breakdowns. Though even these are not perfect, but they will surely act as an extra layer of confirmation and enhance our accuracy.

PCR Ratio

PCR measures the ratio of the put option open interest on a given day to the call option open interest on the same day.

We will check this ratio at the breakout candle, and a few subsequent ones. If the PCR data supports our breakout/breakdown prediction, then we can rely on that breakout/breakdown and enter the trade.

If PCR > 1.25, then it may suggest that the market is going to get bullish. But also have a look at the slope of the PCR data, i.e. whether it’s increasing or not. If PCR slope is downwards or sideways, it may be a false breakout. If PCR changes from much below 1 (say 0.7) to much above 1 (say 1.2), and we are seeing a breakout on the chart, then it probably is a reliable breakout and we will most probably see an uptrend.
If PCR < 0.75, then it may suggest that the market is going to get bearish. But also have a look at the slope of the PCR data, i.e. whether it’s decreasing or not. If PCR slope is upwards or sideways, it may be a false breakdown. If PCR changes from much above 1 (say 1.3) to much below 1 (say 0.8), and we are seeing a breakdown on the chart, then it probably is a reliable breakdown and we will most probably see a downtrend.

So, we should not just rely on our technical analysis of price action, but we should also back that up with data analysis.

Note

To predict breakouts/breakdowns from one day to another, we need to see the end-of-the-day PCR, or see the PCR data at around 3 or 3:15 PM.

Use Indicators

You may also use some indicators, such as MACD (Moving Average Convergence Divergence), RSI (Relative Strength Index), Volume Indicator, etc.

The breakout/ breakdown candle must have more trade volume than the candlesticks before it, otherwise it may prove to be a false breakout/breakdown.

They will provide you a triple-check, and will facilitate your decision making regarding entering into a trade or not.

Wait for Confirmation candle after Breakout/Breakdown candle

Avoid entering the trade right at the breakout candle. Wait for another candle for confirmation.

If you are getting a breakout, wait for the next candle that breaks the high of the breakout candle.
If you are getting a breakdown, wait for the next candle that breaks the low of the breakdown candle.

Then you may enter the trade. Do note that the candle breaking the high/low of the breakout/breakdown candle may or may not be just the next candle. Such a candle may be formed after 2-4 candles after the breakout/breakdown candle. Have patience, and enter the trade only after you get this confirmation.

Identify Chart and Candlestick patterns with better accuracy

Though there are numerous chart and candlestick patterns, some of them maybe more accurate than others. Some of them may even be almost useless.

Though this is very subjective, and various experts will give their own list of so called “accurate” patterns. So, this is something that you will learn with experience. It would be a good idea to analyze each of these patterns in-depth, and identify them on past or live charts and see how accurate they prove to be.

If you want to refer to our list, you may read this article of ours.