Recognizing False
Breakouts And Whipsaws
Swing traders encounter false breakouts and whipsaws throughout
their careers. That shouldn't be surprising, though, because all
we're doing is playing an odds game.
Even a perfect setup can fall apart for no reason and with
little warning. This reminds us that risk management is
mandatory if we want to trade successfully. |
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Breakouts occur in zones of conflict. Both sides of the market
are very passionate at these turning points, but no one knows
how much force is required to carry price into a sustainable
trend. So any position you take near a breakout level carries
considerable risk, no matter how perfect a pattern looks.
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| Price can respond in different ways to breakouts. First, it may
carry through successfully to higher levels. Second, it may
generate whipsaws that force losses on both sides of the market.
Third, it may trap buyers in a false move and start a trend in
the opposite direction. Each of these outcomes requires careful
trade management. |
A successful breakout occurs in three phases. It begins when
price breaks through resistance on increased volume. We'll call
this the action phase. Price expands a few points or ticks, and
then reverses as soon as buying interest fades.
This starts the reaction phase. The market sells off and spawns
the first pullback, where fresh buyers see a chance to get in
close to the breakout price. If all systems are go, a second
rally kicks in and carries price above the initial breakout
high. This marks the resolution phase.
The three phases of a successful breakout depend on certain
volume characteristics. Demand must exceed supply during the
initial breakout. Volume should "dry up" when it pulls back in
the reaction phase. And new buyers need to jump in to ensure a
successful resolution phase. Whipsaws and false breakouts result
when these supply-demand dynamics fall out of balance.
What exactly are whipsaws? Simply stated, they're choppy
price swings back and forth through common support or resistance
levels. Natural tug and pull generates most whipsaws.
But hidden hands also manipulate price through common stop
levels in order to generate volume, and intentionally wash out
one side of the market. Whatever the source, whipsaws are
responsible for many of the losses in a swing trader's
portfolio.
Whipsaws emerge when a breakout can't generate an efficient
reaction phase. This failure may or may not trigger a major
reversal. The pullback shakes out weak hands and forces price
back into resistance.
But there's usually a healthy supply of buyers throughout the
choppy movement. These bulls step in repeatedly to support the
market. A successful breakout can begin quickly after a whipsaw
fades out. The loss of volatility actually triggers a buying
signal on many trading screens. This starts a bounce that
generates the momentum needed to carry price up and beyond the
last high.
Major reversals occur when price action traps one side of the
market. Many traders wait to enter positions at key breakout
levels. Once these folks execute their trades, they're at the
mercy of the market.
In other words, their profits depend on others seeing the
breakout and jumping in behind them. False breakouts occur when
this second crowd fails to appear.
An overbought, one-sided market can drop quickly below a
breakout level. This throws all the traders who bought the
breakout into losing positions. Without the support of fresh
buyers, a stock can fall from its own weight. Each incremental
low triggers more stops and increases fear within the trapped
crowd. Momentum builds to the downside, breaks key support and
invites fresh short-sale signals from a whole new batch of
traders.
