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Breakouts, Fakeouts, and Pullbacks

One key aspect of trading is studying the price action, whether the price moves upward, downward, or sideways. In fact, the price movements in trading are closely monitored by traders using technical analysis and distinguishing between valid breakouts, fakeouts, and pullbacks is a crucial skill for successful trading.


What Are Breakouts?

Generally, breakouts occur when the price of a financial asset breaks or crosses above or below a critical level. These levels can include support and resistance levels, various chart patterns, Fibonacci retracement levels, technical indicators such as moving averages, etc.

When it comes to support and resistance levels, breakouts come in two forms: one above the resistance level and the other below the support level.

A break above the resistance levels (Bullish Breakout)

As explained earlier in our first lesson, resistance levels refer to the areas where the supply is dominating the demand, potentially holding the price from achieving higher levels. On the other hand, the selling pressure around these levels has historically been strong enough to prevent the price from rising further.

A breakout happens when the price successfully breaks above this level, suggesting high buying pressure and a bullish signal.


A break below the support levels (Bearish Breakout)

Contrary to the prior section, within a support level, a breakout occurs when an asset's price declines below a key level of support, potentially indicating a significant and sustained downward price movement.

In other words, it suggests that sellers have taken control, and the asset's price may continue to drop. As mentioned above, breakouts are not limited only to static support and resistance levels. Breakouts from different chart patterns can also suggest a potential trend reversal or continuation.

For instance, a break below a head and shoulders’ neckline may indicate a bearish reversal in the market. Conversely, a break above an inverted head and shoulder pattern’s neckline may indicate a bullish reversal.


What Are Pullbacks?

Pullbacks refer to the temporary and short-term price retracement that occurs after a breakout, either bullish or bearish. Regarding a bullish breakout, when the price pulls back, it enters a retracement or correction phase, retesting the broken level before continuing the upward trend to validate the breakout.

Regarding a downward trend, a pullback refers to when the price enters a correction phase following a breakout, undergoing a brief pause or correction toward the broken level and then resuming its initial downward trend.

In other words, a pullback to the broken level confirms the breakout’s validation and signifies the beginning of a new price movement.

The above picture clearly shows a downtrend, where the price forms lower highs and lower lows, ultimately reaching a critical support region.

However, the price finally breaks below the support level, and after a short-term consolidation, it retraces back to the broken level, forming a pullback. This price action potentially confirms the bearish breakout and signifies the continuation of the prevailing bearish trend.

Let's delve deeper into the idea of a pullback, examining a real example. The chart above clearly illustrates an inverted head and shoulder pattern formed close to a key support region. Following the formation of this well-known pattern, we can observe the price breaking above the neckline, printing a significantly bullish candle.

After the breakout, a temporary retracement toward the broken neckline forms a pullback before the price continues its upward trend. Traders can consider this pullback as a confirmation of the pattern's validity and use it as an opportunity to enter long positions, expecting the uptrend to persist.


What Are Fakeouts?

A fakeout, also known as a "false breakout” or “failed breakout,” occur when the price breaks out of a significant level (a support or resistance level, a chart pattern, etc.) and then moves against the breakout direction, resulting in the breakout’s failure.

Fakeouts are considered deceptive market movements as they initially signal the formation of a new trend and prompt traders to enter a new position in the direction of the breakout but ultimately prove to be a false signal.

In the given chart, we can observe the presence of an inverted head and shoulder pattern, which typically indicates a bullish signal. The breakout above the neckline is often considered a signal to enter long positions, expecting the price to continue rising.

However, the price briefly breaks above the neckline but then quickly reverses its direction, declining below the broken level and forming what is known as a fakeout. Traders who entered positions based on the initial breakout may find themselves in losing positions as the price quickly reverses, leading to frustration and potential losses.

As a result, traders require to use additional confirmation tools and indicators to validate breakouts. An essential confirmation signal that verifies a breakout is when the price subsequently experiences a pullback after a breakout. This pullback indicates the breakout’s validity, prompting traders to consider taking action and identifying suitable entry points based on the pullback.


Significane of Breakouts, Pullbacks, and Fakeouts at a Glance

  • A bullish breakout indicates high buying pressure, and traders tend to enter a long position, anticipating that the price will continue to rise in the breakout’s direction.
  • In contrast, a bearish breakout indicates high selling pressure, and traders think highly that the downtrend will continue.
  • A pullback signals a temporary pause or retracement toward the broken level, acting as a confirmation signal for the breakout.
  • Sometimes, when the price breaks above or below specific levels on the chart, it reverses quickly, tricking traders into taking a position in the initial breakout’s direction. This is known as a false breakout or a fakeout, acting as trap in the market.

The Bottom Line

In brief, breakouts happen when the price breaks below the support or above the resistance levels. On the other hand, pullbacks refer to the correction phase following a breakout before the price continues its initial trend.

Suppose the price breaks below or above a crucial level and quickly reverse instead of resuming the expected direction sustainably. In that case, it's considered a fake breakout, also known as fakeouts!

Breakouts, fakeouts, and pullbacks are a natural part of price behavior, and traders use various strategies, such as technical analysis, trend analysis, etc., to distinguish each of them from another.

Yet, what exactly do these terms signify, and how do they help us to identify genuine opportunities and avoid potential traps in the market? In this lesson, we will delve into the concepts of breakouts, fakeouts, and pullbacks.
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