Understanding False Breakouts and Bull Traps in Trading

Okay, so this is where I started to get dialed in. We’ve got some momentum here; this is actually up over 200%. Look at this squeeze up to $6, up to $6.50, up to $7. All right, I want to buy the first pullback. This thing is strong. What do we see right now? A little resistance at $7, right there at the top of that candle. Let’s zoom in on it. So, we have the top of that candle at $7. It wasn’t able to break $7. Okay, we’ll let it pull back. It comes back up a second time, taps $7 again, but it can’t break it. What’s it going to do next? It comes back up a third try, still can’t break it. Okay, we now have undeniable resistance at $7. All right, resistance at $7.

Now, if it breaks $7, if we get the break of $7, what do you think is going to happen? What typically happens when we break resistance is we squeeze up to the next level of psychological resistance. In this case, that would be $7 to $7.50, then $7.50 up to $8. So, I like this setup, and I’m starting to get dialed in. We watch it pull back one more time; it comes back up, fourth tap of $7. So, we’ve now got one, two, three, four taps of $7, and we haven’t broken it. All right, so now I’m watching traders, and they’re saying, “I’m excited. I want to buy this thing. When this thing breaks this wall at $7, it’s going to explode.” You know, sometimes when you have this kind of resistance, it feels like a dam holding back the water, and when it finally breaks loose, that’s when we get the big move. Often, this is created when there’s one really big seller just sitting right at $7. It’s a whale, and they’re not moving until all their shares are accumulated.

Identifying False Breakouts

So, we get the pullback, and then it comes back up, and people buy more shares. It pulls back, but people buy more shares. It pulls back, they buy more shares. It pulls back, and then finally, what happens? It snaps. It breaks loose. Watch this. Okay, we’ve now got one, two, three, four, five tests of $7. Whoa, we’ve got to zoom out. This candle broke; it went up to a high of $7.60 and then dumped all the way down to $6. Holy smokes, that was 1.5 million shares of volume in one candle. Look at this. That is a scary-looking chart. I don’t like seeing that, not one bit. And you know what? I saw some traders complaining that they just got smoked. They’re like, “I can’t believe it. How does this keep happening to me? Another false breakout. I’m so sick of this.” I know it’s frustrating, but I’m going to tell you that with all of my years of educated intuition, this, well, it starts to become predictable. I’m not surprised that happened right there.

Reading the Chart

Now, you might not notice it yet, but let me have you look at this chart. Is there anything you see here that indicates that this might not have resolved in your favor? Is there anything you can see here that indicates maybe this was more likely to do this kind of pop and then rejection? I can give you a list of a few things, and in this episode, I’m going to share with you the techniques that I use to help me avoid false breakouts. These types of false breakouts, also known as bull traps, can steal a lot of money from your pocket, and it’s not worth it.

It can be incredibly frustrating, especially on a day like this where, let’s just say perhaps, and we’ll scroll back here, we’ll make the chart a little bit bigger, let’s just say perhaps you were someone like me who got in way down here at $3. My first trade on this was at $3. I traded this all the way up from $3 to $3.50, to $4, $4.50, pullback, then up to $5. This was where I made the most money. This was the cleanest move, and I knew that that was going to be the cleanest move. How did I know it? Well, there’s something that I look at on these types of charts. Over my years, I’ve noticed that typically it is the beginning of the move that is the cleanest, and that’s what we have right here, the beginning of the move. Once we get the first pullback, one of two things needs to happen. The first pullback actually was right here, and when you get this pullback and it goes higher, we’re fine. We’re in good shape. I’m going to keep trading it. But once you get a pullback here where it is not able to hold at the nine exponential moving average and it instead breaks that price, that usually means the easy part of the trade is over.

Using Indicators to Avoid False Breakouts

Something you can also use as an indicator is the MACD. This down here is the Moving Average Convergence Divergence indicator, and when it crosses over right here, this is a very important thing to pay attention to. I would say that this marks the end of the front side of this leg up. Now, this could roll over completely and go all the way back down, or it could go sideways for a little bit and rally up one more time, but it’s not surprising that it became choppy. We have the MACD crossover, we go into this period of sort of consolidation and then selling off. We break below our Volume Weighted Average Price (VWAP), so now we’re moving below these indicators. We’re below the 9 moving average, we’re below the 20 moving average, we’re below the volume-weighted moving average, all right, the VWAP. So, this is just weak. And then at the open, you get a little surge of momentum. It squeezes up here back up to its pre-market high of $5. It pulls back just for a moment, does a little false breakout right here. Now, this was an early indicator of what was to come. When you start to see candles like that, it’s a warning sign. You can choose to ignore it, but it is a warning sign, and it’s plain as day.

Warning Signs of a False Breakout

All right, so let’s look at it right here. This was the warning. This was the first one. Look at this candle right here. We had consolidation. We tried to break; it came up to $5.50, the half-dollar, and watch this rejection. It dumps all the way down to about $4.90, and it does it on 700,000 shares of volume. That’s a lot of volume. That’s a big false breakout. That’s a big rejection, and I’m sure there’s people who bailed out. Now, there’s other people who would take an opposite approach, which is to buy the dip, and I do like buying dips on these. Whenever I see this type of candle, I’m typically going to buy the dip. When I see a flush like that, I usually buy the dip, and I set my stop at the low of the pullback. Now, sometimes the way I do it is I let it go red, and then as soon as I start to see green coming in, I start to see some buying. I’ll see it in the actual orders that are going through on the time and sales. At that moment, I press the buy button, I set my stop at the low, and I’m looking for a bounce back up.

So, this actually gave us a nice bounce back up. We got a squeeze here up to this high of $7.10. It drops down, and then in this area here, look at each time we came up, it sold off hard. We come up, it sells off hard. We come back up, it sells off hard. So, the fact that it kept reversing off this level made it very predictable that when it finally broke, likely there’d be a lot of people that would press the sell button for profit-taking, and that’s exactly what happened. In fact, in just 10 seconds, we had over 1 million shares of volume, and it hit a low down here of about $5.95. This was a dip opportunity; it bounced all the way back up to $6.70, but it didn’t hold. Sometimes these dips can rally all the way back up to the high, but they don’t always, and in this case, it came back down, made a new low, and then kind of went sideways before coming a little bit lower.

Understanding Market Dynamics

This is an example of an instrument where it was really thickly traded through this area, and there was a very obvious big seller that was just right here at $7, selling, selling, selling. So, what sometimes happens is when that order finally gets filled, the price breaks, but then another order gets executed. A second order goes through, and it may even be bigger than the first one, and that person is just pressing the sell button. I think that’s what happened here. Someone dumped a ton of shares on this candle. It was probably one or maybe two really, really big orders. They just dumped their shares, and this might be someone who’d been holding for months, maybe years. It probably wasn’t a day trader; it was probably someone who’s been in for a long time, and they said, “This is a good chance for me to sell 500,000 shares, lock up a couple million dollars of profit,” because that’s going to happen when you have something that’s up 200%. You look at the chart, and it’s been beaten up for a long time. You’re going to have insiders who are going to take the opportunity to sell; they’re going to unload.

So, to me, the early part of the move is sort of the safest because this is usually before people are really aware of the fact that the position they’re in is up this much. Pre-market, 6, 7, 8 a.m., most people aren’t going to be aware if they’ve been holding something for a long time how much the market is moving. They won’t even probably check until 9:30, maybe 10 a.m. Maybe they’ll have an alert that’s triggered. So, it’s very, very common that the early part of the move pre-market is super clean, and then as we get into the open, it’s when things get choppy. So, right here, we get this nice move higher on decent volume, but we had one sort of nasty rejection candle, and then we have another one right here. So, what was happening with the MACD at this point? Well, the MACD was actually against the trade, right? We went sideways for too long. This is a problem. When you go sideways for this long, it’s just so obvious that there’s not enough strength. The buyers, they’re not strong enough. The very fact that it’s going sideways is weakness. Now, some people would say, “Look, it’s holding up, it’s holding up.” Yeah, but it’s not breaking higher.

Volume Profile and MACD

And look at these red candles, and let’s look at the volume profile. Which candles have the most volume? Red candle, red candle, red candle, red candle, red candle. So, what’s happening here? Is there more buying, or is there more selling? The volume profile is telling us there’s more selling. The MACD has crossed over against the trade, and we’ve already seen an example of a massive flush right here on a red candle. So, to me, all the warning signs are there. Now, at the beginning of the move back here, there were no warning signs. We had tons of volume; it was all green. So, the way I’m trading this is I’m buying those first pullbacks. This is my strategy for the most part as a momentum trader, but specifically focusing on trading these areas of peak volatility because this is when the chart is the cleanest. I mean, this is when we’re seeing these big moves. This is where I’m making the most money. So, this is what I call my micro pullback strategy. So, as the stock starts to squeeze up, I let it pull back, and then I’m either buying these pullbacks here, or I’m buying this pullback here, or this pullback here, or I’m trading sort of all of them as it moves higher.

Now, for those of you guys tuning in, if you haven’t already downloaded my micro pullback strategy PDF, it’ll be pinned to the top of the comments, and it’ll be linked in the description. So, you can download that, you can print it out, you can put it next to your desk, next to your workstation, and that’s going to be a guide for you on how I trade these types of stocks. It’s going to walk you through how I find the stocks, basically my stock selection process of how I quantify that this is the right type of stock to focus on, and then exactly where I’m getting in and where I’m getting out. All of that is to help protect me from the downside risk of getting caught in bull traps and false breakouts by trading these early. This is when it’s the cleanest.

Characteristics of a Low-Float Stock

So, this stock, by the way, the float on it is 1.3 million shares. So, this is a very low-float stock. This is the type of stock that can make a big move. It’s got the news catalyst. So, in terms of just breaking down what made this the right one to trade, we had the float. Number two, it was already up at least 50% by the time I was seeing it. It was moving fast. Number three, the price is between $5 and $10. This really, for me, is the sweet spot. Now, at the beginning, it was a little bit lower, and that actually did give me some reason to pause on this one. But even in spite of that, it still gave some really good opportunities, and as it got a little higher, it became a little easier to trade. And then, of course, I look for stocks that have high relative volume, and I look, of course, for the catalyst, the news headline. So, when I see all of that, then I’m looking at the chart, and I’m looking for that micro pullback. So, really, it’s just a momentary pause before the next leg up.

Analyzing the Chart in Detail

So, again, if we look at this chart and we start to break it down in more detail, what are we going to see? The MACD was open and in favor of the trade as the price was moving higher. Yes, we got one pullback here, which was fine. It was a light volume red candle. That’s an area to buy the dip. That’s totally okay. I love it. We get to move higher to $5.60. That’s great. And then this area, we’re pulling back, granted on lighter volume, but the MACD crosses over. So, we get the MACD crossover. Whenever we have a MACD crossover, it increases the likelihood that it comes back up here. It’s going to be a double top, and it’s going to reject. Very unlikely for the MACD to be against the trade and for it to squeeze up like this. So, it squeezes up, reverses, not surprising, comes back, double bottoms at about $4.60, and I started thinking about this like, “All right, maybe we could get a leg higher.” So, at this point here, what I’m saying and thinking to myself is, “We’ve got to hold $4.60, and I would watch this to break over this pivot right here, but I most likely wouldn’t buy until the price comes up to that area.” When the price gets up to that area, you know what’s going to be happening to the MACD? It’s going to be crossing back over in favor of the trade. And what’s likely happening is, this is a one-minute chart. On the five-minute, we probably have a bull flag, right? This is a one-minute; this is a five-minute candle. There’s another five-minute candle, another five-minute candle. So, you’ve got green five-minute candles, a little red candle, you know, maybe a candle that kind of made a new high like this, then a candle here. And so, you’re sort of looking at this as an ABCD pattern, right? So, now let’s cross-reference and actually check the five-minute chart. So, we look at this on the five-minute time frame, all right? And now you see, okay, so we’ve got three, was it three big green candles, four big green candles, a pullback, and then this candle tries to push higher but is not able to do it. Now, one thing I would say about this is, look at how extended this is right here on the five-minute off the nine moving average. Oftentimes, when you get something that goes parabolic like this, that’s the cleanest move. Maybe it’ll go up to $7 to $8 in the first leg of that parabolic squeeze, but once it starts to pull back, it really needs to pull back a lot before buyers are going to feel comfortable getting back in. So, it does end up pushing back through the high of $5.50, which sort of surprised me after that rejection candle on the one-minute, but it did push a little higher, and then boom. And you could say, “Well, geez, this even looks like a decent five-minute setup.” Well, it’s a little extended still off of that nine moving average, and unfortunately, the MACD on the one-minute is against the trade. When the MACD is against the trade, when you have a history of these high-volume red candles, and you have already an established history of red candle rejections like that, your odds of seeing this kind of flush are getting really, really high. I’ve just seen it so many times that at this point, it’s predictable.

Checklist for Identifying False Breakouts

So, this is your checklist. These are five indicators that increase the likelihood of seeing a false breakout. One, when the MACD is against the trade. Two, when the volume profile shows high-volume selling. Three, when the stock already has a history of false breakouts. Four, when you have several topping tails in a row or topping tails at the resistance level. And five, when it’s been consolidating for too long. So

Read More: Mastering MACD: A Comprehensive Guide for Traders