Identifying False Trendline Breaks

[RichardCox 10]

One of the most frustrating situations new traders experience is seen when trades are established, based on trendline breaks, only to see prices reverse later and continue as though the break had never occurred. Every trader with more than a few trades under his belt has experienced this, and while it is impossible to avoid false breaks completely, there are methods that can be employed to reduce these occurrences and enter into higher-probability trading setups.

 

To start, we must analyze price activity prior to the break (as a means for determining directional bias). For example, this analysis could be based on an Elliott Wave count, or, even more simply, based on whether or not the currency pair is forming consistent higher highs (for a long position) or lower lows (for short positions). Later, once the break occurs, we can decide whether or not to enter into a trade based on the directional bias prior to the trendline break.

 

Example 1:

 

 

In the example above, we can see that prices were in a firm uptrend prior to the downside break. The break (in and of itself) is a bearish signal and many traders might have chosen to establish short positions on the expectation that the uptrend has completed. But does the other evidence in the chart support this? The first reason for caution comes from the consistent higher lows and highs supporting the uptrend. Next, traders should monitor the way prices behave once the trendline is retested. In this case, prices should have turned downward once the uptrend line was retested (support turned resistance). However, this was not the case, as prices broke through and moved higher.

 

The alternative scenario would be that short positions could be established on the retest of the previous uptrend line, as long as it holds as resistance. The advantage of the (in addition to the confirmation of the trendline retest) is that the trade can then be opened at more preferable levels (i.e. buying lower and selling higher) and improving on risk to reward ratios. In the example below, we can see some differences that would have alerted traders to the fact that prices would be more likely to continue in the direction of the trendline break. Example 2:

 

 

In the above example, we can see that a higher low preceded the upside break of the downtrend line. Once the break does occur, we can see a retest of the trendline (resistance turned support) and here we can see that the trendline holds and prices make a significant bounce higher. In addition to this, indicator readings are bullish and the MACD reading shows a rise into positive momentum. With all of these factors, traders would have a higher chance of entering into a successful long position, with very little drawdown.

 

In conclusion, what traders should remember here is that trendline breaks are not enough (in themselves) to use as an argument for entering into a new position. Other factors need to be considered, and a more careful analysis of price activity prior to (and after the break) can increase the probability of a successful trade.