Updated: Feb 21
Every trader (be it intraday, swing, positional, or scalper) should know how to differentiate a genuine breakout and a false breakout.
Do you know why?
Because any ‘Entry’ and ‘Exit’ in any trade should come through a breakout or false breakout opportunity!
That doesn’t mean other trading techniques will not work. My explanation holds good if a trader is looking for the best entry point and best exit point in any trading technique.
Let me explain in detail.
It’s important to understand two herds that exist in the market:
1. Smart Money and
2. Dumb Money
‘Smart Money’ refers to institutional investors, big sharks who have money and information power who give direction and momentum to markets.
‘Dumb Money’ refers to nonprofessional traders, retail traders who often try to make quick money.
Do you agree that it’s always a good idea to follow smart money?
Then you should know one thing.
Participation from smart money creates a genuine breakout, and the absence of smart money participation results in a false breakout. Isn’t it?
What is a Breakout (Price-Volume Breakout)?
Investopedia website says, “A breakout is a stock price moving outside a defined support or resistance level with increased volume. A breakout trader enters a long position after the stock price breaks above resistance or enters a short position after the stock breaks below support.”
In image 1, the price broke the resistance trend line with high volumes. At the time of breakout, the volatility of the stock will be high.
Similarly, if the price breaks the support trend line, few recognize it as a breakdown.
To keep it simple, we will focus only on the breakout.
But you can find a simple explanation about 'Breakdown' below.
What is Breakdown?
When a stock price moves below the support trend line with a big selling candle, then it will be recognized as a Breakdown.
What is a False Breakout?
A false breakout is also recognized as a ‘failed break’. Investopedia’s definition for a failed break is, “A failed break occurs when a price moves through an identified level of support or resistance but does not have enough momentum to maintain its direction. Since the validity of the breakout is compromised, and the profit potential significantly decreases, many traders close their positions. A failed break is also commonly referred to as a false breakout.”
In image 2, the price showed the characteristics of a breakout. However, it failed in its attempt and broke on the opposite side.
What is Breakout Trading?
Breakout Trading is a simple Price Action Trading technique to take a trade when the price moves outside of a defined range (resistance trend line in case of breakout and support trend line in case of breakdown).
Breakout Trading is a simple technical trading strategy and three concepts play a critical role to identify real breakouts and avoiding fakeouts:
How to Draw Trend lines
How to Differentiate a Real Breakout from False Breakout
Trade Execution Process Flow
How to Draw Trend lines?
A Trend Line is a straight line drawn on a chart by connecting two or more price peaks, which reveals the trend, support, and resistance points, and allows to spot any excellent trade opportunities.
Below points are helpful to draw valid trend lines:
Avoid drawing trend lines on charts in which price action is not smooth (many gaps or wicks).
Consider a minimum of 2-3 peaks to draw a trend line.
A trend line can be considered a powerful trend line when it connects more peaks.
Avoid drawing trend lines with a high slope as it is a sign of an unhealthy trend.
The price should always respect-Trend line.
Image-3, Image-4, and Image-5 show simple examples of drawing a good trend line.
How to Differentiate a Real Breakout from False Breakout using Trend line Breakout?
The four things mentioned below are essential to separate a real breakout from fake ones:
A Big Breakout Candle
Quick Time (the price shouldn’t move in small candles after breakout)
Absence of Selling
Image-6, Image-7, and Image-8 show simple examples for ideal breakouts.
The above charts displayed these four characteristics at the time of breakout, and hence, the price showed a good move on the upside later.
There is a high probability of a good upside move if a chart displays all these characteristics during the breakout. Otherwise, there is a high probability of a false breakout or complete sideways move later.
If a trader prefers to capitalize on big moves in quick time, then he should shortlist the stocks which show consolidation before the breakout. Image-6 is the perfect example of this case as the price consolidated over 10 trading days before the breakout.
Many traders also look for breakout chart patterns to plan their trades. Some of the good breakout patterns are:
Cup and Handle
Inverse Head and Shoulder
Please note if you master the trend line breakout technique as discussed in this article, then there is no to remember any of these patterns.
Trade Execution Process Flow to Trade Different Breakout Patterns (to get low risk and huge returns)
An intelligent trader will have a trading plan before pulling the trigger for a trade.
As a trader, before entering any trade, you should know the bare minimum below five aspects.
Based on your system, where is your entry point?
In case your analysis goes wrong or the trade setup fails, where is your stop-loss?
Where is your anticipated exit based on your system to book the profits?
What is the amount you are risking in this particular trade?
How much amount do you stake on this trade out of your entire portfolio?
As shown in Image 9, Entry should come just a few ticks above the breakout candle's high.
Stop-loss will be a few ticks below the low of the breakout candle.
This stock is showing a breakout pattern from a downtrend. So, one can aim at the beginning of the trend line or topmost swing as the target.
Only opt to take the trade if it shows a minimum of 1:2 Risk-Reward.
Otherwise, you need to ignore the setup and look for better trade setups.
Similarly, one should shortlist Entry-Stoploss-Exit points for breakout patterns in sideways trend and uptrend.
Money Management in Breakout Trading
Any person can quickly come up with a technical system to take trades.
However, money management is the primary key to successful trading.
Do you know why?
In 1995, the Barings Bank, the oldest merchant bank in the UK, went bankrupt after rogue trader Nick Leeson suffered a loss of $2.2 billion.
Nick had a massive long position in Nikkei 225 and he kept on averaging. At the same time, an earthquake hit Japan and his losses multiplied to $2.2 billion which led to the collapse of Barings.
Anything can happen in the world which will have a direct impact on the stock market. Hence, it is always better to control the money we will lose if our trade fails.
Hence, money management is an important aspect of trading.
Positional breakout traders should have clarity on the below questions:
How much to deploy/risk per trade?
How much % of the capital to deploy in trades at any point in time?
How much to deploy/risk per trade?
I suggest a simple technique for this. For one trade, use only 10% of your capital irrespective of the risk.
For example, if you have Rs.1,00,000 as your capital and if you finalize a script ABC, assume your entry price is Rs. 100.
Then 10% of your capital is Rs.10,000. So, you can buy 10,000/100 = 100 Shares.
Using this approach, your entire capital percentage risk per trade varies between 0.5% - 2% (based on how deep your stop-loss is), which is fine.
Some people suggest to risk only 1-2% of your capital per trade, and they don't put an upper cap on the capital. It brings some confusion, and you will not be able to opt for more trades.
Let me explain with one example.
Assume your capital is Rs.1,00,000.
You are planning to risk 2% of your capital per trade, which is Rs. 2000/trade
You had shortlisted a script XYZ – Entry at 1000 and SL at 990.
Then the total number of shared to buy = Rs. 2000/10 = 200 shares.
The capital required to buy 200 shares = 200 X Rs. 1000 = Rs. 2,00,000
But you don't have Rs. 2,00,000 capital in your account, do you?
So, the simple way is to deploy only 10% of your capital on one trade!
How much percentage of the total capital should be deployed in trades at any point in time?
It is a million-dollar question!
I feel no one can answer this question with 100% accuracy or like a formula.
It is effortless to answer, “Deploy 100% of the capital in Uptrend, only 50% in a sideways trend, and sit with cash in a downtrend.”
However, implementing this is a real practical problem.
I have a simple suggestion for new traders.
Never deploy more than 50% of your capital on trades until you experience all market trends (like uptrend, sideways, downtrend, and random).
In other words, you are not supposed to carry more than 5 trades on any given market conditions (except for the remaining 25% of the position on winning trades as you have already made a profit with these trades for 75% position).
Once you cross this stage, automatically, you get the knowledge to increase or decrease your allocated capital based on the market conditions.