You have waited days for your stock to finally break above the technical resistance level. Your buy order was executed flawlessly. Shares poked above the unquestionable technical resistance and you got in at just the right time.
You are confident (based on the earlier upward price move)… that… shares will spike higher after your entry. After all, every technical analysis book and article you’ve read stresses that resistance becomes support after it is broken, right?
A good feeling of relaxation washes over you. For a quick minute, you slip into the kitchen to grab a drink of water.
Upon returning to your trading desk, to your dismay, the stock is down $0.50 from the break out entry level. You immediately close the trade to cut losses… but… can’t understand what just happened.
The above scenario blindsides every trader at some point. I don’t care how long you’ve been trading. The instruments you trade don’t matter either. And neither do any other “mitigating” factors. I know you’ve faced this common problem.
Because it happens to every break out trader.
In fact, it is such a common occurrence it was given a name by traders. It is called being “head faked.”
Head fakes are so common that some traders believe they happen over 50% of the time. A system, called turtle soup, was devised to capitalize on this apparent break out failure rate. I will explain the turtle soup system in another article.
First, let’s examine the basic types of price break outs.
The Moving Average Break Out
This is perhaps the most popular strategy for stock traders right now. This strategy is simple to follow. You just need a moving average and a price chart. The strategy works in any time frame… but the longer the time frame… the more significant the breakout.
I like to use 20 period, 50 period and 200 period moving averages for the break out trading technique.
When short term or day trading, my favorite is the 20 period simple moving average on a 5 minute price chart. This means the moving average is plotted every 100 minutes.
If I am seeking to place a swing trade of 5 to 10 days, I like to use the 50 period moving average on the hourly chart. This simple moving average places a plot every 50 hours to smooth price action over time.
Finally, for those long term investments, nothing beats the 200 day simple moving average on the daily price chart. The 200 day simple moving average is most widely used by institutional money managers and hedge funds… that… rely on technical timing for entry and exits.
The break out occurs when the price bar travels from below the moving average to above the moving average. In other words, the streak through the moving average line is considered a break out.
A picture speaks a thousand words when it comes to learning about break outs. So I grabbed this screen shot from my trading computer this afternoon. It is a five minute chart with a 20 period simple moving average. That’s the blue line in the middle of the red and purple lines.
As you can see, around 10:20 am the price bar broke the entire way above the 20 period simple moving average. This move triggered my buy order… which… created a solidly profitable day trade.
When shorting a stock, a “break out” becomes a “break down.” Short traders should simply do the opposite when break down trading with simple moving averages.
The Trick To Prevent Head Fakes When Trading With SMA Break Outs
Due to the nature of the stock market, there is no way to completely eliminate head fakes when trading simple moving average break outs.
With that said, I discovered a simple way to reduce the number of head fakes. This method requires giving up some profits… particularly… when trading longer time frames. However, the headaches and savings gained more than make up for the lost opportunity.
The secret is to wait for an entire bar to form above the simple moving average before entering the trade!
This takes patience and a hands-on approach. You see, many traders place an order a fraction above the moving average to go long when the price bar pokes through. This is a sure way to get head faked. I suggest waiting for the entire bar to break above the simple moving average. This helps confirm the upside momentum.
Waiting and being patient is a difficult skill to learn. However, it pays off in spades when break out trading.
The Technical Pattern Break Out
Technical pattern break out trading is the second most popular break out trading strategy.
Technical pattern break outs occur when price breaks above a technical pattern believed to create price resistance on the upside. When looking to short, technical pattern break downs occur when price breaks down below a technical pattern thought to provide support.
The most popular technical pattern for break outs is the double and triple top chart formations.
A double or triple top forms when price moves up to a level, falls back and then advances again and is stopped at the same level. Two tries to break through the level is called a double top, three tries and it is a triple top.
Here is an illustration of a triple top break out.
The following is an example of a double top break out.
The key to avoiding head fakes with pattern break out trades is the same as with the simple moving average. Be patient and wait for an entire bar to close above the break out level prior to entering the trade.
The Takeaway
During solid upward trends, break out trading is a proven trading technique. The key to avoiding head fakes is to exercise patience and only enter the trade after an entire price bar has formed above the break out level. While you give up some profits by waiting, the wait makes your overall trading more profitable.
