, LLC, Investment Advisory Services, Cary, NC

How to Avoid False Breakouts

 In Chart Patterns, Hot Stocks


A lot of swing traders are reluctant to trade breakouts for fear that they are walking into a false breakout.  Meaning, the breakout will fail to hold and the price will quickly move down into the prior range.


Recently, we have run across a lot of information on social media regarding false breakouts and how to avoid them.  Much of it does not touch on some very valuable insight so today lets talk about some good strategies to avoid false breakouts.


False Breakouts on Stocks, Forex, Options and Commodities


Some of the most watched videos online on this topic cover examples in the forex market.


One of the best ways to avoid false breakouts is to avoid reversion to the mean assets in the first place.  If you pull up a 5 or 10 year chart of whatever you are trading and there is not a fairly consistent trend upwards, its probably not a great asset to trade breakouts.


So this excludes most commodities, forex and a lot of other assets.  Penny stocks also fall into this category.  In our back-testing and experience swing trading, penny stocks and commodity stocks have significantly more false breakouts than solid growth stocks and biotechs.


High tight flags, the most bullish chart pattern, have a lot more false breakouts when trading penny stocks and commodity-related stocks.  This was true in back-tests of high tight flags and also in a recent back-test on the largest earnings gaps in the 2022 bear market.


Not only do you have a lower win rate, but you also have more risk on a stock or commodity that is in a neutral to bearish multi-year trend.  This includes nearly all penny stocks.


There are some exceptions such as a very strong microcap rally.  However, these tend to end more abruptly than with higher quality stocks.


So the first tip is to pair your reversion to the mean strategy with reversion to the mean assets.   Breakout trading works better on stocks in long-term uptrends.

False Breakouts and Catalysts


It seems obvious, but if something breaks out of a consolidation for no reason, you would think it would have a lower chance of success.


Over the past 15 years we have found this to be true.  Without new news, breakouts often fail to lead to a large move higher.


The phrase “buy the rumor and sell the news” can be taken too far in many cases.  The problem occurs when the price suddenly starts to trend lower into expected news.  We have seen this a lot over the years.


Its better to have fresh news that is much better than expected.  The shorts sometimes get in just ahead of expected news.  If the news is then suddenly much better than expected with a great outlook, they have to cover their shorts which just adds fuel to the breakout and rally.


So have a lot of great chart patterns setting up on your watch list and focus on those that have news that is much better than expected right before the breakout.


Give the Stock a Chance to Consolidate


A good consolidation pattern ahead of the breakout is really important.  In our research, a high tight flag usually needs to consolidate for enough time before the breakout to have a higher win rate.


If the price comes down 50% and then breaks out right away, the stock is too choppy to have a reliable breakout.  Who wants to be in a stock that has wild gyrations up and down?  Its obviously more risky.


We want to see the stock tested with a market pullback where the price holds up in a narrow consolidation and performs better than the overall market averages during the pullback.  This sets up a better chance of avoiding a false breakout.


Strong relative strength during a market pullback is one of the key things to look for.  The length of the consolidation and how narrow it is are important criteria in our optimized high tight flag strategy to help avoid false breakouts.  We also want to see volume falling during the consolidation as it narrows and a volume explosion as it nears a breakout.


See How it Closes


Waiting to see if the stock closes above the breakout point can help but a lot of the best of technical breakouts will run 10% or more right away.  So if the strength of the news, long-term trend, consolidation pattern, relative strength of the industry, float size and short interest, amount of volume and other factors are ripe, we want to get in at the breakout point.


Buying a stock near the close that does not have the fundamental factors to support a big move or during a bear market or correction is not going to help much.  Focus on the strongest growth stocks if choosing this approach.


If You Want a 100% Win Rate, Skip Trading


No strategy is 100% and if there were, it probably would not pay much.


Come up with a set of conditions, good chart pattern qualifications, and what needs to happen near the breakout point and then back-test the strategy over hundreds of stocks in various market conditions.


One way to avoid false breakouts is to avoid trading them during bear markets and market corrections.  In our experience and back-testing, win rates drop substantially when the market averages are at least 10% below all-time or 52-week highs.  Again, researching the bear markets and corrections along with bull markets is key before even using the strategy.


If you like breakouts, our optimized high tight flag strategy is probably the best you will ever trade.



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