Many friends involved in trading will feel a tingling sensation on their scalp when they see the words "fake breakout."

Because in the eyes of most people, a fake breakout implies a loss, and a significant one at that.

The stock market god, Warren Buffett, once said: "When others are fearful, I am greedy; when others are greedy, I am fearful."

When most people fear something, if we go against the grain, we can carve a path through the brutal financial markets.

Today's article will discuss how to change our perception of fake breakouts and how to use them to find good trading opportunities.

1. What is a fake breakout?

A fake breakout occurs when the market breaks in a certain direction, but after the breakout, the market does not continue in the direction of the breakout. Instead, it reverses course and goes in the opposite direction, catching everyone off guard. If we trade on this breakout, it means we have incurred a loss.

In practice, patterns such as rectangle consolidation, head and shoulders patterns, double tops and bottoms, and triangle consolidations can all have fake breakouts. I have written many articles on candlestick patterns on my public account (Eight-Digit Garden), and I recommend everyone to read them in conjunction.

Advertisement

Take a look at the image below for a better understanding.

On the left side of the image:It is a triangle consolidation with a fake breakout pattern. In the image, you can see that after the market underwent a triangular consolidation, a downward break occurred at 18:30 Beijing time. However, after breaking down, the market only moved a very small space before reversing direction and moving upwards, breaking the opposite way.

After the reverse breakout, orders would be stopped out, which is a standard fake breakout scenario in practical trading.

There is another type of market movement that can also be categorized as a fake breakout, which is when you enter a position on a breakout in practice, but the order is eventually stopped out, and it can also be called a fake breakout.

As you can see on the right side of the image:

It is a fake breakout pattern where my order did not trend after entering on a break in practice, and the order was stopped out.

The market formed an upward 1-2-3 pattern break at 16:05 Beijing time, but after breaking out, it quickly pulled back and started to go bearish, and at 20:10 it broke down, the order was stopped out, and the fake breakout was confirmed.

Note:

In practice, fake breakouts can occur at any level of market movement, from as small as 1-minute and 5-minute charts, to as large as 4-hour, daily, and even weekly charts.

2. What are the dangers of fake breakouts?

How do they torment traders?The dangers of a fake breakout are not limited to mere losses.

In practical trading, the most direct and obvious harm of a fake breakout is the order stop-loss, resulting in account losses. However, if it were just about losing money, it would be tolerable, but the harm caused by fake breakouts is not as simple as just losing money.

A series of consecutive fake breakouts in the short term can cause traders to lose control of their mentality, leading to impulsive trading and significant losses.

Within a day or two, if a trader is stopped out consecutively, their mentality will evolve from being able to withstand the first stop-loss, to becoming uneasy, then restless, anxious, angry, and finally fearful, gradually changing.

Anger, in particular, can be a significant issue. When you consistently encounter fake breakouts, you may feel that the market is working against you, and you might be tempted to start gambling on the market, placing heavy positions, and your trading will immediately become distorted, leading to a very painful outcome.

Last week, a netizen shared with me his experience trading crude oil, which is quite representative.

The chart below shows the 15-minute price movement of U.S. crude oil from December 16th to 17th. The market went through four breakouts before it started to move in a true trend, and this netizen was almost driven to the brink.

When he entered the market for the first breakout, the consolidation time frame was reasonable, and the consolidation pattern was standard. The trade was justified based on these factors.

However, after the breakout, there was only a high-level consolidation for two candle sticks, followed by a sharp decline with a large bearish candle, which resulted in the stop-loss of the long position.

The large bearish candle strongly broke through, and the market turned bearish. He shorted for the second breakout, setting the stop-loss at the high point above. But after entering the short position, it only moved one small bearish candle before consolidating and not moving further. Instead of falling, it broke higher again, and the short position was stopped out as well. After these two trades, he lost 130 points.After a series of stop losses, his mentality began to get anxious. When the market broke upward, he continued to go long, but in order to quickly recoup his previous losses, he used a double position size.

His long position did indeed profit, reaching as high as 70 points, but the market quickly retraced. Watching his profits shrink, he became even more reluctant to close the position. Subsequently, he helplessly watched his order hit the stop loss for the third time. It's important to note that the third order used a double position size, resulting in a loss greater than all previous ones combined.

After three trades, the account suffered a loss close to 30%, and he became completely furious. He thought to himself, "The trend must make a move. After being wrong three times in a row, I must be right next time, right?" The fourth trade was almost a full position short.

However, in a trader's bad mood, "anger" and "fear" are closely linked.

Looking at the chart for the fourth entry, the market did indeed move significantly to the downside, but this friend, due to the heavy position, feared another stop loss in the brief period of market volatility after entry and hastily closed the position. This missed the opportunity to turn the tables with a short position, and ultimately, after a few trades, the losses were severe.

This is what traders often refer to as "getting slapped left and right."

When I first started trading, I also had such experiences. As I've discussed in previous articles (trading multiple instruments, using trend line breaks to enter), one afternoon and evening in a period of market consolidation, I was stopped out dozens of times by consecutive fake breakouts, and after being wrong repeatedly, I also increased my position size, trading heavily, and lost over ten thousand US dollars in one day.

3. What did I experience that changed my perception of fake breakouts?

There is a saying: "Familiarity breeds contempt."

It's like being in love; the first time you get dumped, it's heartbreaking, but after being dumped a few more times, you become numb to it and can calmly be a "heartbreaker." Now, looking back at my experiences being hurt by fake breakouts, I realize it's only because I was too young and inexperienced at the time.After being badly bruised by fake breakouts, my first reaction was: I must find a pattern that doesn't have fake breakouts, so that I will never lose money in fake breakouts again.

So I began a long journey of searching.

Rectangle consolidation patterns at 15-minute, 1-hour, and 4-hour structures, the review results were unsuccessful;

Breakout patterns at 15-minute and 1-hour 1-2-3 structures, the review results were unsuccessful;

Triangle consolidation patterns at 15-minute and 1-hour levels, the review results were unsuccessful.

Double bottom and double top patterns, head and shoulders patterns, flag consolidation, and so on, almost all patterns in technical analysis, almost all candlestick time levels, I have reviewed them for many years, and they all have the problem of fake breakouts.

It seemed like I had walked into a dead end, unable to find a solution at all.

But as I reviewed more patterns and experienced more fake breakouts, I began to reflect: does a "pattern without fake breakouts" really exist?

If any pattern, any structure, any level, and any resonance filtering cannot solve the fake breakout, how can profit be achieved?

After a lot of review, I suddenly realized:False breakouts cannot be identified in advance, nor can they be filtered out. To truly profit in trading, one must control small losses during false breakouts and seize large profits during true breakouts, thereby achieving an overall profit in trading outcomes. The management of positions throughout the process is of utmost importance.

In addition, traders should extend their profit horizon. A few consecutive false breakouts are a normal part of market trends.

For instance, if you are trading on a 1-hour timeframe, when the 4-hour timeframe enters a consolidation phase, you will encounter more false breakouts, and the success rate of breaking through will be relatively low.

As long as you can clearly recognize the characteristics of the current trend and take a long-term view on profits, when the 4-hour timeframe enters a trending market, you will also enter a profitable period in trading.

4. Correct understanding of false breakouts

"False becomes true when true becomes false," is an ancient proverb that describes the relationship between truth and falsehood in all things.

With the existence of the false, you come to understand what is true. They are interdependent; if one perishes, the other certainly will not exist either.

First, assume that all breakouts are true, with no false breakouts. Then, every breakout trade would be profitable, everyone would make money, and no one would lose, so whose money would you be making? The financial market would cease to exist.

Then, assume that all breakouts are false. Initially, no one would use the breakout method for trading, because as soon as a breakout occurs, losses would follow.

However, once people discover the pattern of this "false breakout," smart humans would start to trade in the opposite direction during each false breakout, going short on an upward breakout and going long on a downward breakout. The ultimate effect is that false breakouts become true breakouts, leading to the same consequences as the example above.So: the coexistence of true breakthroughs and false breakthroughs is the foundation for maintaining the operation of financial markets. Facing and accepting false breakthroughs in trading is the true path to profit.

Let's talk about something that might sting for many: I actually enjoy false breakthroughs in trading. The reason is harsh but realistic.

The market for trading is a zero-sum game. The money earned by those who profit is contributed by those who suffer losses. The law of the jungle is the rule of the financial market.

From the perspective of the losers:

Encountering false breakthroughs during trading always leads to losses. It's even worse when, like the netizen mentioned at the beginning of the article and myself years ago, we lose our rationality in false breakthroughs, trade heavily, and make the losses increasingly severe, cursing false breakthroughs a thousand times in our hearts.

From the perspective of the winners:

The market has had two consecutive false breakthroughs. Those who are losing can no longer hold back. Let them struggle. As long as I hold my position and temporarily accept the stop loss, it's not a big deal. When the market has washed these people to the point of resignation and they have suffered heavy losses, a true direction will emerge, allowing me to make money.

This is how two types of people in the market have completely different perceptions of false breakthroughs, leading to two very different trading outcomes.

Trading is just that cruel.

False breakthroughs lead many people to make mistakes, lose their rationality, and suffer severe losses; on the other hand, some traders remain calm and rational, completing the harvest.So I repeatedly emphasize that going against human nature and maintaining calm and rationality at all times in trading is the key to finding the most correct opportunities.

5. How to use fake breakouts to make profits in practical combat?

1: How to profit from fake breakouts in practical combat?

After a consolidation pattern experiences a fake breakout that lures both longs and shorts, enter in the opposite direction. See the illustration below.

On the left side of the image is the 1-hour chart of gold, showing a descending triangle consolidation pattern. A descending triangle is usually a continuation pattern for bears, and a break below the pattern implies that the trend will continue to move bearish.

However, in the chart, after the market broke below the support at 1824, it quickly rebounded, forming a reversal candlestick. On the second day, the market broke above the downward trendline pressure above the triangle, and the longs switched from short to long, entering the market which then saw a significant rise.

On the right side of the image is the 15-minute candlestick chart of gold. At the end of a rectangular consolidation, the market made a fake breakout to the downside, which was quickly followed by a candlestick with a long lower wick. Subsequently, the market broke above the upper edge of the rectangular consolidation again, switching from short to long, and after entering, the market rose significantly.

Trading logic:

In a consolidation pattern, after a fake breakout that lures both longs and shorts, the original forces of bulls and bears within the consolidation range are disrupted. Once the fake breakout is established, market sentiment will be pushed in the opposite direction. Therefore, the true direction after a fake breakout usually moves quickly and has a large range, making it a very valuable trading opportunity.

Trading time frames: 5 minutes, 15 minutes, 1 hour, 4 hours are the more commonly used periods.Pay attention to the fact that there are fewer trading opportunities after a fake breakout, so patience is required in trading. You can screen multiple varieties to increase trading opportunities.

2: Special Pattern - Expansion Triangle

The expansion triangle is singled out for discussion because it is the most difficult to trade among all consolidation patterns.

In an expansion triangle, there are usually two to three consecutive fake breakouts. The example at the beginning of today's article is a structure of an expansion triangle, with three consecutive fake breakouts throughout the pattern.

See the illustration below.

After a 15-minute top expansion triangle consolidation, crude oil ultimately chose to break downward, resulting in a significant bearish trend.

There are two very challenging aspects of trading in an expansion triangle:

(1) Consecutive stop losses for three or more times, which is a great test for a trader's mentality, making it difficult for traders to maintain control of their mindset.

(2) Because it is an expanding pattern, in practical trading, stop losses are set based on high and low points, which results in a larger stop loss space, making it hard to achieve a favorable risk-reward ratio.

Therefore, in practical trading, one can directly forgo the trading opportunities presented by expansion triangles. By giving up on the expansion triangle consolidation pattern, the chances of consecutive trading errors are reduced. After a fake breakout that lures long or short positions, the feasibility of entering the market in the opposite direction becomes stronger.