Breakouts vs Fakeouts: Spotting the difference

Markets often move up and down within a set range. Then, the price suddenly goes higher or lower, and it looks like a breakout. You enter the trade, expecting a big move, but the price quickly turns back and traps you. That’s a fakeout, a false signal that tricks traders. Let’s get into the details.

What are Breakouts and Fakeouts?

Here’s a quick breakdown of what breakouts and fakeouts mean in simple terms:

Why do Breakouts happen?

Here are the key reasons why genuine breakouts occur:

• High volume: Breakouts with strong volume show real buying or selling interest. This increases the chances that the move will continue.
• Positive news or events: Strong earnings, product launches, or favourable economic data can trigger breakouts by attracting more buyers or sellers into the stock.
• Technical pattern completion: Breakouts often follow chart patterns like triangles, flags, or rectangles. Once these patterns are complete, the price tends to move sharply.
• Shift in market sentiment: A breakout can reflect a change in how investors feel about a stock or sector, turning bullish after a downtrend or vice versa.

Why do Fakeouts happen?

Here are some common reasons fakeouts occur:

• Low volume: When breakouts occur without significant volume, it usually means there's not enough real market interest to sustain the move.
• Stop hunting: Large traders sometimes move prices just enough to trigger retail traders’ stop-loss orders. Then they reverse the move, trapping others who thought it was a real breakout.
• Lack of catalyst: Without strong news or events to justify the breakout, the price move often lacks strength and quickly reverses.
• Overcrowded trades: When too many traders expect a breakout, the setup becomes vulnerable to traps, leading to quick reversals and losses.

Breakouts vs Fakeouts: Key differences

Here’s a quick comparison to help you spot the difference between breakouts and fakeouts more confidently:

Signs of a true Breakout

To avoid getting trapped by fake breakouts, look for these simple signs before entering a trade:

• High volume supporting the move: High volume during a breakout shows more people are involved, increasing the chance that the price will keep moving in the same direction.
• Price closes well above/below the Breakout level: When the price closes significantly beyond the breakout zone, it signals strong market momentum and reduces the likelihood of a quick reversal.
• Multiple retests of the breakout zone (with Support): A retest with the previous breakout’s level as support marks the breakout as confirmed and encourages traders to trade that trend.
• Confirmation from RSI or MACD: Direction in RSI (Relative Strength Index) or MACD (Moving Average Convergence Divergence) matching the outcome of a breakout removes doubt and increases the possibility of success.
• News, earnings, or macro data backing the move: When earnings are strong or good economic data, those breakouts become more trustworthy and likely to last.

Red flags that signal a Fakeout

Early recognition of a fakeout means there is a better chance of avoiding losing money. Listed below are the indicators that someone might be in distress:

• Thin volume during the Breakout: Breakouts on low volume are not always reliable and carry a high risk of reversing or becoming fake.
• Long wicks (Shadows) beyond the level: If the wick of a candle goes past support or resistance, this generally means the breakout did not have much confidence.
• Sharp Reversal in the Next Candle: A strong reversal right after the price breaks out is considered a common fakeout sign.
• Bearish divergence on Momentum indicators: When the price advances but the RSI or MACD slides down, the move's strength is reduced, and a false break can be expected.
• No clear reason for the Breakout: Such a price swing taking place without reason, like a surprise event or news, hasn’t much strength and often doesn’t last long.

Tools to use for confirmation

To confirm if an upward move is genuine or not, you can rely on these tools:

• Volume profile: Allows you to find zones where a lot of activity occurs, so you notice where the market’s buying and selling pressure builds up.
• Moving averages: The trend has strengthened when a price moves above significant moving averages.
• RSI/MACD: With the help of indicators such as RSI and MACD that remain in line, the probability of a real breakout increases.
• ATR (Average True Range): Measures recent price volatility, helping traders set informed stop-loss levels and avoid getting caught in unpredictable market swings.

Spotting the right signal

Breakouts and fakeouts are part of every trader’s journey. Learning to tell the difference between them is a challenge every trader must overcome. It is not always clear if a breakout or fakeout has happened, but you can spot familiar patterns with time. Always use the price action, checking the volume, and confirming the action with certain indicators.