Breakout versus Fakeout

by Amanda Harvey

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Introduction

Identifying a breakout versus fakeout is very important when determining trading strategies. Understanding these terms, and how to distinguish between a genuine breakout, and a false alarm or ‘fakeout,’ is a key to making good trading choices.

Defining Breakout versus Fakeout

As the name implies, a breakout involves a situation where the price ‘breaks out’ of its previously defined range. A breakout occurs when a stock price rises above its current resistance level, or falls below the existing support level, and this movement is accompanied by a high volume of trading.


If a movement outside the levels of support or resistance occurs with a low volume of trading, this may not indicate a true breakout, but rather a fakeout – a breaking of the support or resistance levels that does not indicate an oncoming trend, but rather a dramatic short-term price move that will subsequently revert to within the trading range.

The Significance of Trading a Breakout

Breakout trading involves strategies that allow the trader to enter a trend in its early stages, and to ride the wave that a true breakout is usually expected to produce.

Once a stock price ‘breaks out,’ there is usually evidence of increased volume, and a trending of prices, in the direction of the breakout. Breakouts are often identified as the starting point of a significant price trend.

How to Identify a Stock Ready to Break Out

While a breakout is a term that applies to stocks both rising and falling outside their normal range, it is most often used in relation to stocks that are breaking out above their resistance levels.

In identifying an upcoming breakout, it is suggested that the most likely candidates are stocks which are close to their two month high when they begin to surge upwards.

In recognizing a breakout versus fakeout, chart patterns are an invaluable tool. Patterns such as head and shoulders, triangles or flags, can provide evidence of a genuine breakout and a valuable trading opportunity.

Examining the existing support and resistance levels can also provide important insight regarding a breakout. The more frequently the price has touched these levels, the more ‘solid’ they can be regarded as being, and the longer these levels have been in effect, the more influential a breaking of them is apt to be.

Points to Consider Before Trading the Breakout

When chart patterns and study of support and resistance levels have shown a viable breakout trading opportunity, the trader should consider some further points in executing the trade.

It is not usually advisable to enter a trade immediately upon the breaking of an existing level, but rather to seek confirmation that this is indeed, a breakout and not a fakeout. This confirmation can be found in the level of volume accompanying the price move. As mentioned above, a breakout should be accompanied by a high trading volume. Another strategy often implemented by traders is to wait until close to the end of the trading day, to make sure that the movement outside the previous range can be sustained before entering a breakout trade.

In Conclusion to Breakout versus Fakeout

A breakout can present a great opportunity to trade with an emerging trend, and with the ability to distinguish breakout versus fakeout, identify an upcoming breakout, and confirm a breakout in its early stages, a trader can capitalize on this opportunity as it is presented.


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