Episode 6 – Signs of a True and False Range Breakout August 31, 2022

Introduction

When analysing market trends and movements, we find that two-thirds of the time, trades fluctuate in a price range without any significant up or down trend. This is also known as a Sideways trend. This leaves us with the remaining one-third of the time, where the market is trending in a pronounced direction. Hence, it is essential for traders to know how a price range is formed, what constitutes a true breakout or what prolongs a Sideways trend, so that they can recognise the change in phases.

When and how does a range occur?

Before exploring how to differentiate between a true and a false range breakout, let us first understand when and how a range or Sideways trend occurs.

A Sideways trend is a horizontal price movement that occurs when the forces of demand and supply are relatively equal. This usually takes place during a period of consolidation before the price continues a prior trend or reverses into a new trend (a breakout).

There are 2 possible reasons for a market to trade in a range:

1. When there are no trigger events

The lack of trigger events such as quarterly / annual result announcements, new product launches, geographical expansions news, collaborations, etc. can result in sideways movement.

2. The market is in anticipation of a big announcement

Till the announcement is made, both buyers and sellers are hesitant to take action, and hence the stock falls into a range. The range under such circumstances can last until the announcement (event) is made.

When analysing trends, trading volumes speaks volumes. When a stock is trading in a range, its trading volume usually remains flat because it is equally balanced between bulls and bears. The stock shoots up (or down) sharply in one direction when a breakout (or breakdown) is expected to occur.

Thus, during a Sideways trend, traders would rather focus more on the nature of the Sideways trend rather than make trades. This is necessary in order to determine which position you should take, and will help to determine the moment the Sideways trend transitions into the impulse phase. The transition to the impulse phase of the trend is realised when there is a breakout of the side line border, which can be both true and false. Good traders must be able to differentiate these breakouts.

The Logic of False Range Breakouts

To identify a false breakout, you need to analyse the most common formations of false breakouts. False breakouts are meant to lure new traders into wrong positions during trading and to test the residual strength of the opposing-trend movement. The 2 main distinguishing features of false breakouts are:

1. The minimum volume at the time of the breakout of the range, and the volume of trades can greatly increase before that.

2. A large concentration of orders and trades towards a return to the trading range.

Apart from referring to the volume indicator, we can refer to the Moving Average Convergence Divergence (MACD) indicator as well. MACD is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. A false breakout could be supported by a small MACD histogram indicating that momentum is low.

In addition, the price often takes an engaging run-up right before a false breakout. This will result in an increase in trading volume when the price is reaching the lateral border. This lures trading participants into a pretence that the infusion of money from professionals has begun. Hence, traders should be aware of this ‘false’ signal.

A good analogy is what happens in hurdling. In order to jump over an obstacle, a runner must jump before it, not after. Likewise, when trading volume increases before reaching the border, the liquidity that is present is actually absorbed into the Sideways trend. Therefore, upon recognising that the opposing trend is still strong, the pros use this trading strategy they continue to collect liquidity, but not without allowing others to fuel a false breakout of the range in order to stretch traders along the stops.

Another sign of a false breakout is a fall in volume when prices are near the border of the range (support and resistance lines), especially if there is a large number of candles with long wicks up to that moment. This is a result of the pros luring trading participants into the position.

In summary, a false breakout happens when a ‘not so trigger friendly event’ occurs, with impatient retail market participants reacting to it. Usually, the volumes are low on false range breakouts indicating that there is no smart money involved in the move. After a false breakout, the stock usually falls back within the range.

The Logic of True Breakouts

A true breakout of the range should combine these 3 signs:

1. Completion of liquidity accumulation in the sideways body

2. Increased volume towards the breakout

3. After the breakout, the momentum (the rate of at which price changes) is high – indicated by the MACD

It is good to remind ourselves that a true breakout is usually not the first breakdown of a Sideways trend. This is because the passengers will first disembark and trim stop orders, after which a clear impulse in the direction of the trend will be launched.

Before a true breakout, the quantity of orders and movements by the opposing trend are already minimal and hence any large trades in the direction of a true breakout will be able to move the market in the appropriate direction. This indicates an unobstructed path towards the breakout.

From a technical analysis aspect, before a true breakout, a series of candles will usually appear in the direction of the breakdown, closing at their extremes or having small wicks. This indicates that the strength of the opponents of the breakout movement is weakening, hence signalling that the movement will continue rather than reverse. In addition, the breakout itself is often carried out by a long candlestick, which closes at its extremum.

Thus, a true breakout occurs when the liquidity of the range levels have been reduced to minimum and there has been at least one false breakout that has trimmed the stops. At the same time, a true breakout will be supported by an increased volume, which moves the market towards the breakout.

It is important for traders to not be tempted and learn to ignore false breakouts. Traders should trade true exits outside the price flat. Observing the nature of the price range breakouts and understanding what constitutes the formation of a true breakout could lead to profitable trades.

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