Traders face the never-ending confusion of the financial markets, where one of the biggest problems is that of false breakouts and false trend starts. While it can be extremely difficult to differentiate a valid breakout from a false one, there are some simple rules of thumb that every trader can use, and most of these rules are effective enough so as to detect major false breakouts and help avoid losses.

 

The very first and possibly simplest rule is that of trading volume, whenever the market attempts to break out, in either direction, but trader participation is low due to holiday periods or just low for any other reason, then the move in question has a good chance of being a false one. The market tends to make solid moves only during periods of high or at least average trader participation, where trading volume is somewhat average or higher. Another important rule is that of falling support and rising resistance trendlines. If the market seems to have breached a falling support trendline, or a rising resistance trendline, then the move is almost certainly a false one, even though it may last for many days, it will eventually run out of steam and the market will reverse. Solid breaches require rising support trendlines (for valid sell signals), and falling resistance trendlines (for valid buy signals). Traders can figure out right away what the slope of a trendline is on the daily chart, just by looking at a market chart spanning several months.

 

It is also a fact, especially in commodities, that if a trend has been set in motion and the market rallies too much too fast, in a way so that the slope of the rally, as seen on the chart, seems to be steeper than around 45 degrees, then the rally is said to have been overextended and at some point  price will correct lower. The problem with identifying such parabolic trends is that there is no easy way of predicting when the reversal, and downward correction will begin. The theory of parabolic trends works in both directions as well, even a market that has fallen at a trend slope of more than 45 degrees will at some point correct to the upside. So, in other words, trends that last long, should  have slopes at around 45 degrees, even on their weekly charts.

 

There are minor exceptions to all these rules, but the rules of trading volume and that of trendlines are the easiest to use. There are some rare chart patterns where the market can breach a falling support and still yield a valid sell signal, but these patterns tend to last for a short time anyway, and the expected move is also brief, which fits the profile of the theory since even false moves can last  many days when they occur. What the trader knows about these false moves is that they are bound to fail, at some point, it might be in 10 days, or in 30 days, but they all end up failing and the market reverses back to its pre-breach levels, and even beyond that.

 

graph false breakouts

The above chart shows the SP500 stock index, notice the orange trendlines, the one on the left is showing a falling resistance, and when the market breaches that trendline at the blue arrow a valid buy signal is produced, despite the lack of momentum it is a valid buy signal. The other trendline on the right defines a falling support, when this is breached by the market at the blue arrow it calls for caution, as it is going to be a false sell signal, it could have the market going down for as many as 30 days and then reverse back up, it is possible, but in this case we see a typical false signal where the market reverses within few days.

 

Trendlines are correctly defined by the trader when they are drawn over two or more points (highs or lows), even just two such points are enough to define a valid trendline. One more exception to the trendline breach signals is when there is a parallel channel in place, the market may remain in the same overall trend, and not change at all as seen on the daily chart, but it can breach the trendlines of the originally defined parallel channel and expand into a bigger parallel channel which  leads the market in the same direction as before (up or down). To avoid confusion, traders pay attention to the formation of such parallel channels, as these channels are simply two trendlines parallel to each other, and the bigger channel will always override any smaller channels within itself. Traders also pay attention to the overall slope of a parallel channel, if it is too steep it is bound to end sooner or later and all the movement the market made will be retraced. Traders know that markets cannot move and stay outside their solid support and resistance levels, and any attempts that the market makes to exceed these levels, especially on suspicious low volume periods, are bound to result in breakout failure and reversal. This is because when the market is about to move even beyond fundamentally sustainable support and resistance levels, it requires many more buyers or sellers to join the action and make it move and stay there, if these buyers or sellers are not available the breakout is doomed to fail, at least for sometime. Even fundamentally sustainable levels may be tested 3 or more times before finally enough buyers or sellers are available, so as to produce a solid breakout.

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