No matter if you're an investor, day trader or swing trader, you are exposed to the whipsaw of the danger zone - and it may be hurting you if you act impulsively. Anytime there is a pattern characterized by particular boundaries within which a stock fluctuates, a "danger zone" develops. This is the area just outside the established range. It can be called a danger zone because there are many conflicting interests in this area.

There are those that want the breakout to occur and are making transactions in that direction. There are those expecting the range to continue and are "fading the breakout." There are also the "predators" who may trigger the breakout only to drive the price back into the range. Finally, there are those who are waiting for the momentum to wane and then aggressively take the trade back the other direction.

Here we are going to focus on capitalizing on false breakouts by using a "danger zone" in conjunction with other indicators to verify that sometimes we should not trust the breakout, and should trade in the opposite direction instead. (Learn how to distinguish tops and bottoms in the equity market when short selling. Read Finding Short Candidates With Technical Analysis.)

Experience the Danger Zone
All experienced traders have seen it. A stock (or any instrument) has been within a defined trading range for some time and appears to have found its comfort zone. Buying ceases at a certain level and then selling commences. Selling continues until buying comes in aggressively at the low of the range and sellers back off. However, this balance breaks suddenly and the stock begins to move aggressively higher out of the range. The movement is sharp, attracting the attention of other traders and they pile in long for the big "breakout" trade.

The longs are happy for a few minutes, but then a trading horror story is realized as prices plummet back into the trading range and the selling continues at a pace far more aggressive than the buying. The trader feels taken; caught by a whipsaw at an opportune level for the predators. Moreover, the trader likely incurred slippage on both entry and exit in the fast-moving market, making this trade twice as frustrating. Factor in transaction costs, and the scenario becomes even worse.

The real problem is that this happens very often, and traders mistakenly believe that this will change. As algorithms and black box trading becomes more prominent, it's likely the opposite will occur and these whipsaws will become even more prominent. Still, traders need to see this as an opportunity and not a detriment. In other words, each of us will need to be a predator from time to time, and capitalize on the market mistakes of others.

What Is the Danger Zone?
As previously explained, the danger zone is the area where large competing interests come together. It is the pivotal level that was moved through triggered orders in both long-term and short-term directions, including the scalpers that may be involved in the trade. This all normally happens within a confined space around the previous defined range (or pattern) after the stock breaks out. True breakouts and false breakouts will possess certain characteristics that can be analyzed and implemented in profitable strategies.

Working the Zone
As with any strategy, this one is not 100% accurate, but by being informed we can capitalize on speculation-driven breakouts that have failed. The words "have failed" are used on purpose, since we are going to exhibit patience and wait for the market to signal us to enter in the opposite direction of the break. In fact, we are not going to trade in the danger zone at all.

What to Look For
In Figure 1 you will see an hourly chart of SPY, an easily accessible ETF that tracks the S&P 500 index. On three consecutive days, December 2, 3 and 4, we see the market make new highs, only to move quickly back into the established range (marked by the long horizontal lines). The false breakouts are labeled one 1, 2, 3 and the short horizontal lines show the breakout level of each progressive move.

Figure 1: Hourly chart of SPY showing false breakouts
Source: Free Stock Charts

The obvious thing is that in order for a breakout to fail, it must move back through its breakout point. Strong breakouts "break" and sprint higher (or lower in case of downward breaks), but then they move back to the original range. This breakout point, which was formerly resistance, should now act as support for the pullback. In the case of a downward breakout, the reverse is true. If it fails to act as support and the stock continues to move below the defined upper band, it signals a short-term failure of the breakout. (Discover how these influential levels can switch roles. Check out Support And Resistance Reversals.)

This is our first signal: A move outside the established range, which then pulls back into the range. As an example, at Point 2 of Figure 1, we will have already marked Point 1 as our high. When Point 2 occurs, we begin to short this market in anticipation that the price will drop back to its original range below Point 1. At Point 3, we already know the high at Point 2. When the market rallies above Point 2, but then falls back below that price, we again enter short sales. These are not our only signals - we may want confirmation from some other indicators that will justify shorting a stock that was being aggressively bought only moments ago. That said, the aforementioned indicator set is our main tool.

Figure 2 zooms in on the SPY intraday action using a 10-minute chart.

Figure 2: A 10 minute chart of SPY showing false breakouts.
Source: Free Stock Charts

Each price point moved above a former high, then collapsed in an equally aggressive fashion. But this does not mean that this type of trading strategy can only be used in the absence of a market trend.

Becoming a Predator
Traders need to show patience to capitalize on the exuberance of other traders. Also, this strategy may mean missing the chance to get into some legitimate breakouts early - waiting until we are sure that a profitable trade can be executed. If it is a true breakout, it will move in the upward direction for some time. Therefore, we have set levels marked in the securities we follow, and likely have some sort of "alert" to notify us when a level is surpassed. When the security moves through an old high we quickly check two metrics:

  1. Volume: Increased volume on a breakout increases its odds of success, especially on upside breakouts. Light volume on a breakout means it is more likely to fail. However, decreasing volume on a downside breakout doesn't necessarily increase the likelihood a breakout will fail.
  2. Divergence: A relative strength indicator (RSI) or some other oscillator can be used to signal that a reversal is probable. If RSI is failing to make new highs as the price continues to rally, we have confirmation that this breakout has a good chance of escalating aggressively in the near future.

We wait for our trade and, if the other above indicators are working in our favor, we will likely see the trade soon. If not, we wait for another opportunity.

Entry
We enter our trade when price moves back through the breakout point into the previous price range. Add a small buffer to this price to adjust for potential slippage.

Stop
Our stop on the trade is just above the previously observed high, which we set as our target price. We know false breakouts occur, so we want to be out of our position before the pullback happens. (For more on stop orders, see A Logical Method Of Stop Placement.)

Profit Target(s)
Many exit strategies can be used once in the position. False breakouts can be aggressive but also short lived. Therefore, a preferred method is to take some profits at a 1:1 reward-risk ratio. If the desired level of risk is a potential 25-cent loss on the trade, take most of your profits after a 25-cent move in your favor. Exit the remainder of the position at 2:1 and 3:1 reward to risk.

Bottom Line
False breakouts occur all the time. We can be on the wrong side of them or the profitable side of them. When a security enters the danger zone, watch for signs of weakness. When they appear, the strategy is simple: enter in the opposite direction of the breakout when prices move back through the breakout price, set a stop at the extreme and take profits at multiples of risk. You can also choose to use other indicators to help in our trading decisions, but you should only use the strategy on patterns and not while strong trends are in place. (A thorough understanding of these can help you locate important entry/exit points when the markets make the turn northward. For more information, check out Support and Resistance Zones - Part 1.)

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