Swing Trading False Breakouts from Rectangles

Category Slug: swing-patterns

Excerpt: This article presents a contrarian strategy for swing trading false breakouts from rectangle patterns. Learn to identify these common "fakeouts" and profit by trading against the trapped breakout traders.

Breakout trading is one of the most popular forms of trading, but it is also fraught with peril. False breakouts, or "fakeouts," are a common occurrence, and they can be a major source of frustration for traders who jump on board a breakout only to see it reverse and stop them out. However, for the savvy contrarian trader, false breakouts can be a golden opportunity. This article will teach you how to identify and trade false breakouts from rectangle patterns.

The Psychology of a False Breakout

A rectangle pattern is a period of consolidation where the price is trading in a range between a clear support and resistance level. A breakout occurs when the price moves above the resistance or below the support. A false breakout is a breakout that fails to follow through and quickly reverses back into the rectangle.

False breakouts are driven by the actions of both amateur and professional traders. The amateurs are the ones who chase the initial breakout, buying high in the hope of selling even higher. The professionals, on the other hand, are often the ones who fade the breakout, selling into the buying pressure of the amateurs.

When the breakout fails to attract new buyers, the price stalls and begins to reverse. This triggers the stop losses of the breakout traders, which adds fuel to the reversal and sends the price back into the rectangle.

Identifying a False Breakout

There are several clues that can help you to identify a false breakout in real-time:

• Low Volume Breakout: A genuine breakout should be accompanied by a surge in volume. A breakout that occurs on low volume is a red flag and is more likely to be a false breakout.
• Quick Reversal: A false breakout is characterized by a quick reversal back into the rectangle. The price should not spend much time outside of the range.
• Bearish/Bullish Candlestick Patterns: Look for bearish reversal candlestick patterns, such as a shooting star or a bearish engulfing pattern, on a false breakout to the upside. Look for bullish reversal candlestick patterns, such as a hammer or a bullish engulfing pattern, on a false breakout to the downside.

Entry Rules

• Short Entry (False Breakout to the Upside): When the price breaks out above the resistance level of the rectangle and then quickly reverses back into the range, enter a short position.
• Long Entry (False Breakout to the Downside): When the price breaks down below the support level of the rectangle and then quickly reverses back into the range, enter a long position.

Exit Rules

• Profit Target: The profit target for a false breakout trade is the opposite side of the rectangle. For a short trade, the profit target is the support level. For a long trade, the profit target is the resistance level.

Stop Loss Placement

• Short Trade Stop Loss: Place your stop loss just above the high of the false breakout.
• Long Trade Stop Loss: Place your stop loss just below the low of the false breakout.

Risk Control and Money Management

• Position Sizing: The false breakout strategy offers a very favorable risk-to-reward ratio, as your stop loss is placed very close to your entry. Calculate your position size based on your risk tolerance and the distance between your entry and stop loss.
• Discipline: It takes discipline to trade against the crowd, but it can be a very profitable endeavor. Stick to your rules and don't be swayed by the initial excitement of the breakout.

The Specific Edge

The edge in this contrarian strategy comes from exploiting the predictable behavior of the breakout trading crowd. By fading false breakouts, you are trading against the trapped breakout traders and profiting from their pain. This is a high-probability, high-reward strategy that can be a valuable addition to any swing trader's toolbox.