Breakout, Breakdown and False Breakouts in Trading

 Hello, esteemed traders. Progress in financial markets depends on developing the right strategies and understanding market movements. Especially in a fast-paced and dynamic environment like Forex, whether price levels break through support and resistance zones or fail to do so creates inspiring opportunities for traders. Such breakouts are defined in technical analysis as "breakout" and "breakdown." However, not every breakout is as it appears. At times, we encounter "false breakouts," which can mislead traders in the market.

We will discuss the concepts of breakout, breakdown, and false breakout, their types, and how they can be identified in this article. We will also touch on the critical role these movements play in creating a successful trading strategy. If you want to better understand price movements and strengthen your strategies, this article is just for you!

What is a Breakout?

The first step to succeeding in financial markets is understanding the logic behind price movements. In this context, one of the frequently used concepts in technical analysis is a breakout. A breakout refers to the situation where the price of an asset surpasses a certain resistance level and makes an upward move. This situation is generally interpreted by market participants as the beginning of a new uptrend. The resistance level can be thought of as a barrier where the price struggles to move upward. Surpassing this level indicates that the buyers in the market have gained strength and the sellers have weakened. In other words, when the resistance is broken, buyers' confidence in the market increases, which can result in more buying interest. Breakouts are particularly important for trend-following traders because breaking through resistance usually occurs with strong momentum, indicating that the price may reach higher levels. Therefore, breakouts are often used as buy signals.

What is a Breakdown?

A breakdown occurs when the price of a financial instrument falls below a specific support level, initiating a downward movement. This is often interpreted as the beginning of a new downtrend in the market. Breakdowns are considered to be an important sell signal for traders because when a support level is broken, it indicates that sellers are outnumbering buyers in the market and that the price may continue to fall. The main idea behind breakdowns is that the price of an asset has found support at a certain level for a long period of time. This support level is usually a point at which traders are willing to buy, as there is an expectation that the price will bounce back as it approaches this level. However, when the price falls below this support level, this expectation is disrupted and market sentiment changes. Sellers start to sell with the expectation that the price will fall even further, causing the price to decline more.

Breakdowns can be influential not only from a technical analysis perspective but also from a fundamental analysis standpoint. For example, a company reporting lower-than-expected earnings, a deterioration in economic indicators, or overall negative sentiment in a sector can trigger a breakdown in the market. Therefore, traders should assess such movements using both technical and fundamental analysis tools. In summary, the term "breakout" refers to an upward price breakout, while "breakdown" refers to a downward price breakout.

Types of Breakouts and Breakdowns in Forex

1. Regular Breakout/Breakdown (Basic Breakout/Breakdown or Simple Breakout/Breakdown or Standard Breakout/Breakdown)
2. Strong Breakout/Breakdown
3. Gap Up Breakout and Gap Down Breakdown
4. False Breakout/Breakdown (Fakeout/Fakedown)

Regular (Simple or Standard) Breakout/Breakdown

Simple (Regular or Standard) Breakout: A simple (standard) breakout is when the price breaks through a certain resistance level and reaches a new high. This type of movement is generally considered a buy signal in the market, as breaking through resistance indicates strong buying pressure and suggests that the price may continue to climb to higher levels. However, not every breakout signifies a major price surge. Simple breakouts often exhibit low volume, indicating that the movement lacks momentum and the breakout is unlikely to be sustained. A standard breakout with low volume can be a warning sign for traders, as movements with low volume are generally not sustainable. Therefore, the breakout movement often experiences a brief loss of momentum, causing the price to pull back toward its initial levels. After such a regular breakout, the price may temporarily retrace toward the broken resistance level. This retracement is known as a pullback and often presents an opportunity for traders, as the price retests the broken level. If the price holds above this level during the retest and does not fall back below it, the validity of the breakout is reinforced, increasing the likelihood of the new trend continuing.

So, even a simple breakout can create buying opportunities. But it's important to see if the volume and momentum are strong. And if the price tests the breakout level and doesn't break through, it's a stronger signal that the trend will continue. Below is a chart of the GBP/USD pair featuring an example of a standard breakout (also known as a "regular breakout" or "simple breakout"). In this chart, you can observe how the price tests a specific resistance level and then breaks above it. By analyzing the breakout point and the subsequent price movements, you can gain a better understanding of how the market reacts to such situations.

Standard (Simple) Breakout on GBP/USD Chart

Simple (Regular or Standard) Breakdown: A regular breakdown occurs when the price falls below a certain support level, reaching a new low. This is generally perceived as a sell signal for traders. However, the market does not always immediately confirm this movement. After breaking the support level, the price may briefly rise again, almost as if retesting the broken support. This can sometimes create concerns among traders about a possible false breakout.

The price makes a short upward move toward the broken support level and then directly tests it. This test is a crucial moment to determine whether the market accepts this new low. If the price fails to move back above the broken support level, the regular breakdown is confirmed. Following this, the price action continues in the direction of the breakdown, leading to the formation of a new downtrend. This process can create new selling opportunities in the market or signal that existing positions should be closed. In the 4-hour CAD/JPY chart below, you can see an example of a standard (regular) breakdown. You can examine how the price breaks the support level on the chart and the movement that follows this breakdown.

Standard (Simple) Breakdown on CAD/JPY chart.

Strong Breakout/Breakdown

Strong Breakout: A strong breakout is when the price forcefully breaks through a resistance level. A strong breakout is like the price shattering a resistance level. This type of breakout is often supported by a surge in buying orders, and results in the price rising relentlessly. The price may continue to advance without returning to the broken resistance level. These types of breakouts are often sustained, meaning the price will move a significant distance before any pullback. These strong breakouts indicate that buying demand is outweighing selling pressure, showing that buyers have taken control of the market. As a result, this can be an ideal time for traders to open long positions. Additionally, after such breakouts, the previous resistance level often transforms into a new support level, reinforcing market stability and increasing confidence in the continuation of the new trend. A perfect example of a strong breakout in action can be seen in the Bitcoin/USD 1-hour chart below.

A Strong Breakout on the Bitcoin chart.

Strong Breakdown: A strong breakdown is when the price forcefully breaks through a support level. These types of movements are often supported by a surge in volume and are considered a sign of strong bearish momentum in the market. During a strong breakdown, it is common for the price to enter a downtrend or for the existing downtrend to accelerate. In these types of strong breakdowns, the price typically continues to fall without retracing back to the broken support level. The chances of a pullback (brief retracement) is very low, as the downward momentum in the market prevents any price recovery. This situation can be a clear indication for traders that the market has entered a strong bearish (downward) trend. Strong breakdowns often indicate the overall weakness of the market. After such a movement, traders usually anticipate that lower levels will be tested. Therefore, these types of breakdowns can present great opportunities for short (sell) positions. An example of a strong breakdown can be seen in the Spot Gold/USD 4-hour chart below.

A Strong Breakdown on the Gold chart.

Gap Up Breakout and Gap Down Breakdown

Gap Up Breakout: A gap up breakout occurs when the price opens a new trading day with a noticeable gap above the previous closing price. This usually indicates strong buying demand among market participants, creating an optimistic sentiment and increasing the probability of prices moving to higher levels. A gap up breakout is often observed after market-moving developments such as major news, positive economic data, or a strong corporate earnings report. It shows that traders believe that the price should go higher than where it is, which translates into strong demand to buy. The main feature behind this type of movement is that the price opens at a level higher than where it previously traded, creating a visible gap in the chart. A gap up breakout is often observed when resistance levels are broken and can signal the beginning of a new trend. However, gap up breakouts are not always sustained. If the price quickly retraces after the opening and the gap gets filled, it may be considered a false breakout. Therefore, when analyzing gap up breakouts, traders should carefully evaluate factors such as trading volume, market conditions, and the price's ability to hold above the breakout level. Below is an example of a Gap Up Breakout in the U.S. Dollar Index chart:

Gap Up Breakout in U.S. Dollar Index.

Gap Down Breakdown: A gap down breakdown occurs when the price of a financial instrument opens below the previous closing price, leaving a noticeable gap. This happens at the beginning of a new trading day or session and signals strong selling tension in the market. The factors driving such a breakdown often include:

• News and Events: Events such as negative news, an unexpected decline in company performance, deterioration in economic data, or negative developments in the industry can shake investor confidence, causing the price to start at a low level at the opening.
• Market Sentiment: Negative general market sentiment, especially after bad news that comes while the markets are closed, can lead traders to rush to sell at the opening.
• Technical Analysis: If an asset's price breaks through key support levels identified in technical analysis, it can trigger a gap down breakdown. Traders may adjust their positions in anticipation of an opening below these levels.

An example of a Gap Down Breakdown trade can be seen on the 4-hour chart of the FTSE 100 UK Listed Shares Index (UK100) below:

FTSE 100 Gap Down Breakdown.

A gap down breakdown can be seen as a sell signal for traders, as it indicates that sellers have taken control of the market and raises expectations of further price declines. Following this breakdown, the price usually does not attempt to fill the gap and may initiate a new downtrend. However, in some cases, the price might retrace to fill the gap, offering short-term buying opportunities. As a result, gap down breakdowns present both risks and opportunities. Traders should incorporate both fundamental and technical analysis, prioritize risk management, and consider overall market sentiment when making decisions after such a move.

False Breakout and False Breakdown (Fakeout and Fakedown)

"False Breakout/Breakdown" and "Fakeout/Fakedown" generally refer to the same phenomenon and are often used interchangeably in technical analysis. Both terms describe a situation where the price appears to break through a support or resistance level, only for the move to be false, as the price quickly reverses back to its previous range. However, sometimes there are minor nuances depending on the context of use:

• Fakeout & Fakedown  usually seen on shorter timeframes (e.g., 15-minute or 1-hour charts). It often results from market manipulation, such as stop loss hunting, and is characterized by a quick reversal with low momentum.
• False Breakout & False Breakdown is more common on higher timeframes (e.g., daily or weekly charts). The price moves in the breakout direction for a while before reversing, making it a more prominent false signal in the broader market context.

False Breakout (Fakeout): A false breakout happens when the price appears to break above a resistance level but quickly reverses. Although it seems to surpass the resistance, the move fails to hold, and the price soon retreats, continuing to trade below the resistance level. In the 4-hour USD/CAD chart below, an example of an upward false breakout is illustrated. A false breakout occurs when the price temporarily breaks above a resistance level but fails to sustain the move, leading to a swift reversal. In the given example, the price initially surpasses a key resistance level but is unable to hold above it, eventually reversing downward. When the price breaks resistance but quickly retreats and initiates a downward move, it's a characteristic sign of a false breakout.

False Breakout on the USD/CAD pair.

False Breakdown (Fakedown): A false breakdown occurs when the price appears to break below a support level but quickly reverses. Although it seems to drop below the support, the move does not hold, and the price soon rises back above the support level, continuing to trade above it.

Refer to the 1-hour NASDAQ Index (US Tech 100 Cash) chart below for an example of a false breakdown:

False Breakdown in NASDAQ Index (US Tech 100).

False breakouts (False Breakout/Breakdown) occur when the price gives the impression of breaking a support and resistance level, but the move is not sustained, and the price quickly reverses. This phenomenon is often the result of market dynamics, investor psychology, and specific market conditions. Here are the main causes of false breakouts:

• Stop-Loss Hunting: Large players (e.g., hedge funds, banks, or liquidity providers) are aware that the market has concentrated stop loss orders at certain levels. In this case, they move the price toward these levels to trigger the stop loss orders. Once these orders are activated, they provide liquidity, which the large players can use to enter positions. As a result, the price quickly reverses back to the previous level, making the breakout a false one.
• Low-Volume Breakouts: For a breakout to be reliable, it typically needs to be supported by high trading volume. However, if the volume is low, the breakout is often temporary. Without sufficient buyer or seller support, the price tends to return to the support and resistance level.
• Misleading Market Moves: In some cases, traders misinterpret news or data releases, leading them to expect the price to move in a certain direction. The price moves in line with this expectation, but the market later reacts according to the actual fundamentals, causing the price to reverse. As a result, a false breakout occurs due to incorrect fundamental analysis.
• Consolidation and Volatility Trap: During consolidation periods (sideways movement), support and resistance levels are frequently tested. Short-term breakouts may occur during these tests, but the price is unable to hold above or below the level. As a result, false breakouts form while the market attempts to find its direction.
• Manipulation: Some large traders or algorithmic trading systems may intentionally push the price below or above a certain level to manipulate the market. Their goal is to trigger a reaction from smaller traders and take positions in their favor. After the manipulative move, the price usually returns to its previous level.
• Indecisive Market Conditions: In an uncertain economic environment or just before an important data release, the market can become indecisive. In such situations, prices may temporarily break through support and resistance levels, but once the uncertainty clears, the price can return to its previous levels. Ultimately, indecision leads to false breakouts.
• Technical Errors and Unnecessary Fear: Some traders interpret even small price movements as breakouts and take positions based on these signals. However, such moves are often incorrect and lead to a market reversal. Panic selling or premature buying can trigger false breakouts.

It seems that false breakouts can stem from both the strategies of large players and the natural dynamics of the market. They can mislead traders by providing false signals. Therefore, it's important to use stop loss orders when trading. Also, it is necessary to wait for a few candle closes above (for a breakout) or below (for a breakdown) the broken level for confirmation.

Remember: Breakouts and breakdowns observed in the market can be misleading. To avoid falling into the trap of false breakouts, never trade without confirming price movements. Don’t neglect using stop loss orders for risk management.