Failed Breakouts and Reversals: Profiting from Deception

Meta Description: Learn how to turn failed breakouts and reversals into profitable trading opportunities. This guide covers the art of trading against the crowd.

Category: swing-earnings

Slug: failed-breakouts-reversals-trading-guide

In the world of trading, what doesn't happen is often more important than what does. A breakout that fails to follow through, or a trend that suddenly reverses, can be a effective signal that the market's expectations were wrong. This article will teach you how to profit from these moments of deception, by trading against the trapped traders who bought the breakout or chased the trend.

We will explore the psychology behind failed breakouts and reversals, the key technical signals to look for, and the specific strategies to capitalize on these high-probability setups.

Entry Rules

Trading failed breakouts and reversals is a contrarian strategy. The goal is to identify a situation where the majority of traders are likely to be wrong, and then take the opposite side of the trade.

Catalyst Qualification:

1. The Failed Breakout: The stock attempts to break out of a key resistance level, but then quickly reverses and closes back below the breakout level. This is a sign that the breakout was not supported by genuine buying pressure.
2. The Reversal: The stock is in a clear uptrend, but then experiences a sharp reversal on high volume. This can be a sign that the trend is exhausted and a correction is imminent.

Technical Entry Setup: The Bull Trap

A bull trap is a classic failed breakout pattern. It occurs when a stock breaks out to a new high, only to reverse and trap the breakout buyers.

1. The Breakout Attempt: The stock breaks out above a well-defined resistance level.
2. The Failure: The breakout fails to hold, and the stock closes back below the resistance level. The candle on the day of the failure is often a bearish engulfing candle or a shooting star.
3. The Entry Trigger: The entry is triggered when the stock breaks below the low of the breakout failure day. This is a confirmation that the sellers are in control.

Indicator Settings:

• Volume: 50-day moving average of volume. Look for high volume on the breakout failure day.
• Moving Averages: 10-day, 20-day, and 50-day SMAs.

Exit Rules

Exiting a failed breakout trade requires taking profits quickly, as these moves can be fast and furious.

Profit Targets:

1. First Profit Target (PT1): Take partial profits (1/2 of the position) at the nearest support level.
2. Second Profit Target (PT2): Take the remaining profits at the next major support level.

Stop Loss Placement

1. Initial Stop-Loss: The initial stop-loss should be placed above the high of the breakout failure day.
2. Maximum Stop-Loss: The stop-loss should not be more than 5% above your entry price.

Position Sizing

Use the same fixed-risk position sizing model as described in the previous articles.

Risk Management

1. Confirmation: Do not short a stock simply because it has reached a resistance level. Wait for the confirmation of a failed breakout before entering the trade.
2. The 2% Rule: Never risk more than 2% of your account equity on a single trade.

Trade Management

1. News Flow: Be aware of the news flow for the stock. A positive news announcement could invalidate the failed breakout setup.
2. Market Trend: Be mindful of the overall market trend. It is generally easier to short a failed breakout in a bearish market than in a bullish market.

Psychology

1. Contrarian Mindset: Trading failed breakouts requires a contrarian mindset. You are betting against the crowd, which can be psychologically challenging.
2. Discipline: It is important to have the discipline to wait for the confirmation of a failed breakout before entering a trade. Do not try to anticipate the failure.
3. Emotional Control: Failed breakouts can be volatile and emotional. It is important to remain calm and stick to your trading plan.