Recognizing False Breakouts & Whipsaws
The market is generating its fair share of colorful phraseology these days. Many traders are calling it nerve-racking or unreliable, while Cody's classic use of the term "dislocations" should find a permanent home in the Terminology Hall of Fame. But is this market really any different from the past?
Of course it's not. The market is bobbing and weaving the same way all stocks, sectors and indices do the majority of the time. Prices trend for a little while and then spend endless weeks testing higher and lower boundaries. Our frustration in playing this market is really a matter of perception, not reality.
The real driver for trader pain this year is the endless series of whipsaws and false breakouts. It feels as though common knowledge of price levels is being used against traders in a conscious and diabolical manner. Of course there's a reason for this ominous feeling. It's absolutely true.
Many computer algorithms running the market these days spin off public trader strategies at key price levels. Big money knows it can control price direction, regardless of where the herd is charging at the time. So it implements computer programs that fade the herd's response in order to trap them and generate quick profits.
However, swing traders encounter whipsaws and false breakouts throughout their careers, and we can't always blame our fate on cold-hearted computer programs. In fact, simple crowd psychology does a great job by itself of generating false breakouts, in most cases without the assistance of hidden forces.
So how do we deal with whipsaws and false breakouts? First, realize that traders spend too much time predicting the future and not enough time just managing what the future offers. Then remember that everything we do in our trading activities is simply an odds game. This reminds us that risk management is a required skill for survival.
Breakouts, as well as 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 needed to carry price into a sustainable trend. So any position you take near these key levels carries considerable risk, no matter how perfect your patterns and setups look.
Price can respond in different ways to breakouts: It can carry through successfully to higher levels; it can generate whipsaws that force losses on both sides of the market; and it can trap buyers in a false move and start a trend in the opposite direction. Each of these outcomes requires customized trade-management rules.
Here is a set of observations about breakouts and breakdowns that has saved me thousands of dollars over the years. For the sake of simplicity, I'll focus on the breakout scenario. Commit these to memory and use them the next time you're working through these setups. You'll see the universal dynamics here in all markets and all time frames.
Successful breakouts occur in three phases. They begin when price breaks through resistance on increased volume. We'll call this the action phase. Price then expands a few points or ticks and 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 positioned near 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, which confirms the initial rally through resistance.
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. Then a healthy supply of new buyers needs to jump in to ensure a successful resolution phase.
Whipsaws and false breakouts result when these supply-demand dynamics fall out of balance. Whipsaws are defined by choppy price swings through common support or resistance levels. Natural tug and pull generates most whipsaws, but hidden hands also manipulate price by hitting common stop levels in order to generate volume.
Whatever the source, whipsaws are responsible for many of the losses in a swing trader's portfolio. This choppy action emerges when breakouts or breakdowns don't generate efficient reaction phases. This annoying failure may or may not trigger a major reversal.
In a healthy breakout scenario, the reaction phase shakes out weak hands and forces price back into resistance. But there must be willing buyers throughout the choppy movement. A breakout can't succeed unless these bulls step in repeatedly to support the market.
The resolution phase 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 through the initial high. That event signals successful completion of the breakout and the initiation of a new buying opportunity.
Reversals occur when price action traps one side of the market. Many traders wait to enter positions at key breakout levels. These folks are at the mercy of the market once they execute their trades. In other words, their profits depend on others seeing the same 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 quickly under its own weight.