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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.
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.
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.