Read our Breakout Trading – Trading Range to Trend Guide Part 1 before reading more on Breakout Failure here if you haven’t!
Our article on breakout (even in Part 1) is not implying that every breakout trade works or that short term traders are destroying themselves by exiting their trades on failed breakout. Breakouts do fail rather often and price movement following these failures can be violent.
It is noticeable that markets will probe levels for resting orders, and seeking out levels that will create trading volume. It is not difficult to figure out where these orders might be placed. Traders use previous pivots and visible support and resistance levels to define risk points for trades. Stop orders tend to cluster just outside the day’s range or more or less predictable chart levels.
A simplified model can elaborate a hypothetical situation, say if you are a large player that is trying to sell some of your inventory in a futures market. And say that the market has a resistance level at $80.00 that lasted several test. We can also assume that many traders will short against this visible level. If this is the case, traders would put their stop perhaps in a range of $80.01 or $80.02.
What do we do when the market reaches $79.98? Remember, we are holding a long position as a large player that we’re comfortable with. We would want to sell some but at a price as high as possible. One good way to achieve that is to actually buy more at $79.98 or $79.99 which would push the market to $80.01. Even though we need to sell, the most effective way for us to sell is to begin buying more.
If we are right, and the short traders have their stop orders clustered around that range, these stops will trigger. Hence, a rush of buying pressure will come into the market. As soon as the stop triggers, we can stop our buying. Which is extremely good because we are even longer than we previously are. Only then we will be happy to sell a significant portion of our position into the volatility resulted by these stops order. In the end if we continue selling the rest of our inventory after the burst of stop orders completes, the market is likely to roll into a strong-sell off!
This is a simplified model of what happens in the market but it happens all the time in all time frame.
Breakout Failure Test of Breakout Level
Breakout Failure test might have different definition among traders. So to be clear, what I mean failure test in this article is the simple case of market trades beyond a significant level just far enough to trigger a stop without any significant follow through beyond that level.
A failure test is a brief movement beyond a level and then comes an immediate reversal. The term immediate also depends on the time frame we are looking at. As a rule of thumb, we want to see no more than 2 or 3 bars on our time frame outside the breakout level and then a strong momentum reversing the move.
Lower time frame price action is the key to judging the probabilities around this trade. Say for example in a case of an upside breakout. Buyers are swept into the market by the breakout then they will sell their position if the breakout fails. These exits behaves in an urgent manner ranging from mild to outright panic. Hence creating a downward momentum. It is unlikely to have this kind of price action without price going back below the breakout level.
Looking at the chart example below, we compare the price action of two or three bars following the two points of A to the same time period B. In the first two cases, once a bar closes back on the other side of the breakout level, strong momentum steps in to the other side. Hence, the strong price rejection from the breakout level. This price rejection is an important pattern of support and resistance holding. Which in this case, the level is holding after being broken.
Even though point B would have been a successful fade of breakout level, the action following B is not typical of action following the best trades. The market spent too much time consolidating too closely to the level.
It is also important to consider another variation on this pattern. Which is the reversal bar actually doesn’t show strong reversal momentum. As such, the close of that bar may occur very close to the breakout level, either inside, outside or maybe at the breakout level. Nevertheless, lower time frame price action shows a lack of conviction beyond the breakout level.
For example, in the case of an upside breakout, bounces would be slow and reluctant on the lower time frame. And the market may be perceived as moving down with much less resistance than it move up. This type of market may be holding at higher levels without strong underlying conviction. If this pattern emerges, a sharp breakout failure momentum back inside the level is likely to emerge within the next several bars.
If the above paragraph doesn’t happen, then it is more likely that a simple pullback after the breakout is underway. Remember that it doesn’t need to hold outside the breakout level. This is one of the most complex and subtle area of chart analysis. It is more like an art rather than science. So traders need to be ready to make adjustment to positions as market structure unfolds.
Failed Pullback Following a Breakout
A pullback after a breakout represents a potential first pullback of a new trend. So many of these trend failure patterns associated with other pullbacks apply to this pullback. With ONE SMALL EXCEPTION. If the breakout level was truly an important level, there should be high activity on the breakout. It is uncommon to see breakout pullbacks fail by going into flat ranges. On the other hand it is more common to see breakout pullback fail with very strong momentum out of pattern. Or fails on the second test of the extreme reached after the pullback.
This is because there are usually many competing factor and too much order flow for the market to just go dead after a breakout. If a consolidation happens after a breakout, it is usually indicative of a successful breakout. The fact that market was able to hold above the breakout level shows there is conviction behind the move and can often sustain in the breakout direction.
For traders that are seeking failed breakouts setups, the best pullback failures we’ll see is a sharp reversal and failure out of the wrong side of pullback formation. This indicates a complete breakout failure of conviction outside the breakout level.
If sharp momentum occurs against the breakout direction confirming the breakout failure, the first pullback is probably tradable. We could trade against the direction of the breakout. As this pattern describes what usually comes after the best failure patterns, we need to consider our position. It is not useful to make decision at the time of the breakout. However, if we find ourselves holding a position against this failure pattern as it develops, large loss is probably coming.
If we don’t have a position while this breakout failure pattern emerges, it may offer reasonable spot to scalp or short term trade against the breakout. But it is most certainly a warning to get out of a breakout trade if we are holding a losing breakout trade.
The below figure may give some clarification on this matter. Point A shows a typical breakout and at point B the market is consolidating in a standard pullback. At this point, it is justifiable to hold a long position as long as the lower time frame price action is favorable. However, point C shows a classic breakout failure pattern, a sharp downside momentum breaking down the bottom of the pullback.
The move following point C is on a very strong momentum downward (against the direction of the breakout). And the trend leg following point C is longer and steeper than the previous downtrend. Hence, shorting pullback at point D could be a good trade based on this criteria. In this case, it is also motivated by the breakout failure of the breakout level at A. So when price turns down after this pullback at D, some panic will occur as the last trapped longs traders will scramble.
In a higher time frame, this will look simple with a bar of strong momentum away from the breakout level or a price rejection at breakout level. Although there are many variation, fundamental price patterns are relatively simple and consistent.
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