1-2-3 Breakouts and Breakdowns
Traders encounter whipsaws, fakeouts and false breakouts throughout their careers. They shouldn’t be surprised though, because all we’re doing is playing an odds game and even a perfect trade setup can fall apart for no reason, and with little warning. This reminds us risk management is not optional if we intend to trade. It’s absolutely required on each open position.
Breakouts and breakdowns occur in zones of conflict. Both sides of the market are very passionate at these turning points, but no one knows how much force will be required to carry price into a sustainable trend, higher or lower. As a result, any position you take near a breakout or breakdown 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.
Successful breakouts occur in three phases, which I’ve marked 1, 2 and 3. It begins when price breaks through resistance on increased volume. We’ll call this the action phase (1). Price expands a few points or ticks, and then reverses as soon as buying interest fades. This starts the reaction phase (2). The market sells off and spawns the first pullback, where fresh buyers see a chance to get positioned close to the breakout price. If all systems are “go”, a second rally kicks into gear and carries price above the initial breakout high. This marks the resolution phase (3).
The three phases of a successful breakout are dependent upon certain volume characteristics. Demand must exceed supply during the initial breakout. Volume should “dry up” when it pulls back in the reaction phase. New buyers need to jump in to ensure a successful resolution phase. Whipsaws and false breakouts result when these supply and 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 trader’s yearly performance.
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 to resistance but new buyers keep a floor under the instrument, stepping in repeatedly to support higher prices. A followthrough rally, which confirms the breakout, can begin quickly after a whipsaw fades out. The loss of volatility when a whipsaw dies down 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 their 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 other traders seeing the same breakout, and jumping in behind them. False breakouts occur when this second crowd fails to appear on schedule.
An overbought market can drop quickly below a breakout level when the second group fails to show up. This throws all the traders who bought the original breakout into losing positions. Without the support of fresh buyers, a stock can fall from its own weight. Each incremental low triggers more stop losses, and increases fear among the trapped crowd.
Momentum builds to the downside while the instrument breaks key support and fresh short sale signals ring, bringing in even greater selling pressure. One trend ends and another begins in the opposite direction.