Consider the following scenario.
You’ve had EURUSD on your watch list for weeks. More specifically, you’ve been waiting for a break below a key support level to take advantage of the selloff that’s sure to follow.
After three weeks of practicing saint-like patience and unshakable discipline, the Euro finally sells off against the US dollar and closes below support.
The wait is over!
You open your trading platform, enter the necessary details of the trade and place a limit order. Before you go to bed, you work out what the profit will be one last time out of sheer excitement.
The following morning you awake to find that not only did EURUSD fail to respect former support as new resistance, but it also rocketed 200 pips higher against the USD taking out everything in its path including your stop loss.
The pair goes on to close the day back above your key level, negating the entire trade idea as well as your bearish bias.
Sound familiar?
Sure it does. We’ve all been there. Even the best looking trade setups can and do fail on occasion.
But the million-dollar question is, why did this happen?
Better yet, how could you have mitigated the risk or perhaps even benefited from the false break itself?
That’s what you’re about to learn. By the time you finish reading this lesson, you will have a firm understanding of what false breaks are, why they form as well as how to take advantage of them.
Read on to learn about this little-known trick.
What is a False Breakout?
First things first, before you can learn how to use false breakouts to your advantage, you have to know what they are and how to identify them.
A false break, or breakout, as the name implies, is any move (and subsequent close) above or below resistance or support respectively followed by a reversal that fails to respect the broken level as new support or resistance.
Let’s take a look at an example.
Notice how NZDJPY closed above channel resistance on a 4-hour basis but subsequently failed to hold above it as new support.
What’s important to note here is that we’re dealing with closing prices. If a currency pair merely pierces a critical level, it is not considered a false move.
For example, I see a lot of traders incorrectly labeling the two instances below as false breaks.
Whether you consider these false breaks depends on how you define a “break.” For me, a breakout requires the close of a candle, and because I trade the daily time frame 90% of the time, it often involves a daily close above or below the level in question.
If we revisit the EURGBP chart above, the daily candle merely pierced resistance, so to label this as a false “break” is inaccurate as the candle never actually broke (closed above) the key handle.
Now, if you had been trading the 15-minute chart, the decision about whether or not it’s a false break would have been different. Having said that, the technique I’m about to show you is only accurate when used on the higher time frames such as the 4-hour and daily charts.
There is often too much “noise” on the lower time frames to adequately gauge what is a false break and what is not.
This brings us to the next, very important subject of time frames.