Be Wary of False Breakouts

When looking at breakouts driven by technical analysis, I always comment that any breakout needs to be sustained. By that I mean the share price should remain above the breakout price for a period of time, relative to the period of time over which the trend/pattern formed . What you don't want to see is a breakout that is quickly reversed. If that occurs, it is known as a False Breakout.

-  An upwards false breakout signals that buying pressure is not significant enough to create further upwards movement
-  A downwards false breakout signals that selling pressure is not significant enough to create further downwards movement

False breakouts can therefore be a good sign of when it may be appropriate to buy or sell further stock, as it represents when the bulls or bears have run out of steam. The best way to illustrate this, is through examples. Below are 4 different examples of false breakouts on company share prices, and one on the FTSE 100 (as a testament to how commonly these can occur for some of the shorter timescales). The importance of waiting for breakout confirmations should become clear. Remember breakouts can lead to significant price movements in the same direction, if followed through reliably.

False downwards breakout in NetPlay shares during an upward wedge formation
False upwards breakout in Paragon Diamonds shares during a symmetrical triangle pattern
False upwards breakout in Solo Oil shares during a descending triangle pattern
2 False upwards breakouts in Kenmare Resources shares when near to the upper trendline
False downwards breakout at established support in the FTSE100 index chart

Those are just 5 examples of false breakouts that have taken place recently. Being able to spot when a breakout is real or false is of importance. Whilst it varies dependent on the situation, here are a few points to look out for:

1. Check the volumes = If the volumes are larger than normal, the breakout is more likely to be sustained and less likely to be false. Also, check the proportions of buys and sells upon breakout. Is the breakout sold into or bought into?
2. Check the indicators = Are the indicators showing the stock as being overbought or oversold? That can help determine whether a retracement will occur and whether there is a possibility that the breakout could be false. For example, if a share breaks out when the RSI is highly overbought, there is an increased chance of a pullback, and that could lead to a false upwards breakout being confirmed
3. How significant is the breakout? = The larger the share price movement post breakout, the more likely it is real as opposed to false. Also look for intra-day trends. If there is an intra-day downtrend formed post-breakout, it could well be false. Paragon Diamonds is a clear example of that
4. Do the fundamentals support the breakout? = Ultimately, always check whether the valuation of the company at the price target can be supported by investors (i.e. is it still an attractive proposition). If a company is in your opinion, overvalued, and there is a downwards breakout, is it more likely to be real? Conversely, if there are preliminary signs of an upwards breakout, is it worth selling into, in case it turns out to be false? Is the breakout news driven? If it is, it is less likely to be false