The Psychology of a false break in Forex
False breaks in the Forex market are intensely psychological events that essentially involve two types of traders; professionals who trade based on logic and pre-planned trading setups and ideas, and amateurs who trade based on how they feel and who enter the market when it “feels safe”.
It is safe to assume that the most emotional traders are the ones that buy near the top of a move or sell near the bottom of it. Why? Because as a move gains steam in one direction it begins to attract more and more traders, eventually as the move approaches the point of termination all the traders who have been sitting on the sidelines watching can no longer resist the urge to get a part of the action. It is usually about this time that the market is ripe for a pullback in the other direction, because everyone is now “committed” and there is no one else on the sidelines; the pros have made their money or have locked in their profits, and the amateurs are about to suffer some probably very large losses (because amateurs also tend to risk too much).
As the market subsequently flushes out all the amateurs who bought near the top or sold near the bottom, it accelerates in a counter-trend manner until everyone who traded based on their emotion and “feeling” is reduced to rubble, and it is about this time that the market is ready to resume its pre-correction direction with the dominant trend.
So, what does the above have to do with false breaks? Well quite a bit actually. False breaks occur when the all the amateurs are on board, and as we discussed above, there is no one else on the sidelines. A false break can occur within the context of a trending market or it can occur at the apex or trough of a major move.
Now, not all of the concepts in this article are “trade setups” that you can literally trade, but they are good to be aware of so that you understand the psychology behind what is happening when a false break occurs and also just for your general understanding of price action and market dynamics.
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Bull and Bear trap – false breaks
Bull and bear traps are essentially just “general” false breaks that occur at the apex or trough of a move, like we discussed previously. A market moves in one general direction and then typically it will terminate in a false break of some sort, whether it is in the form of a pin bar false break, a fakey false break, or the less defined bull or bear trap.
To understand this concept let’s look at an image of the current daily chart of the EURUSD. We can see a fine example of a bear-trap that occurred after 4 consecutive days of falling prices. On the 5th day, the market broke below support near 1.2950 but then closed higher. This was the “trap”; all the amateurs felt safe after 4 days of declining prices and so they assumed that if the support broke it would be a good time to sell. After everyone was on board short, the market then rallied hard for 4 days in a row, no doubt forcing liquidation of everyone who sold near the bottom; the pros were already in from higher levels and had profits locked in, or were simply not in at all.
You see it is a very easy thing to understand; people who trade with no definable plan or who have not “mastered” a few simple price action setups, will typically just trade when it feels good; thus they end up buying tops and selling bottoms. As price action traders we can take advantage of this information buy looking to get in at obvious market turning points or in the midst of an obvious trend by learning to trade simple PA setups which reflect the emotion and unpreparedness of the amateurs.
Next, we can see an example of a bull-trap in the chart below. Note it occurred after a sustained up move that provided a solid inside bar entry once resistance was clearly broken and closed above. The logical setup in this up move was that inside bar setup that formed just on top of old resistance / new support near 1.3400 (see where it says “good inside bar trades”…the first one).
Also, pin bars can be bull or bear traps. After a large move in one direction, if a pin bar forms showing a counter-trend move is possible, this would be considered a bull or bear trap. In the chart below we can see an example of a pin bar bull-trap where it says “amateurs bought here because it felt safe”. It is called a bull trap because the last bulls have been trapped, and a bear trap because the last bears have been trapped.
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Pin bar – false breaks
Pin bars can often occur as false-breaks too, not necessarily as “fakey setups”, but rather as a pin bar that is also a false-break of a level (so no inside bar is present prior to the pin bar false-break, thus it’s not a fakey). See in the chart above where it says “pin bar / false break”, we can first see a pin bar / false-break of resistance near 1.3400, and then we had a pin bar / false-break that occurred within the structure of the up-trending market, this was more of a false-break of a “minor” support level that ran through 1.3500.
Pin bar false-breaks can be very powerful trade setups and I consider them one of my primary trading tools and I look for them often, so should you. They can occur in both trending and consolidating markets.
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Fakey – false breaks
The fakey setup is an inside bar false break. So, an inside bar MUST BE PRESENT for a fakey setup to form, the actual false break of the inside bar is the defining characteristic of the fakey setup. Classic “major” fakeys occur when the mother bar experiences a false break as well as the inside bar, “minor” fakeys occur when just the inside bar experiences a false break but the mother bar does not; minor fakeys are only valid on daily chart
The psychology behind the fakey setup is equally as interesting and intense as bull / bears traps and pin bar false breaks. The psychology of a fakey setup can be explained in terms of the condition the market is in when the fakey forms.
If the market is trending and a fakey setup forms which implies trading in the direction of the trend, then the fakey was formed as a result of traders trying to pick the top or bottom of a trend that was not ready to pull back to value yet. Generally speaking, amateurs are not only buying the tops and selling the bottoms, but they are also trying to pick tops and bottoms, this may seem a bit counter-intuitive but it makes sense if you break it down:
Traders who operate on emotion are typically going to be the last ones in on a strong move, because they aren’t following their trading strategy, or they don’t have one, they are waiting until it “feels good” to enter, which is usually right before the market is ready to reverse. We often see fakey setups form as the very last amateurs enter the market and the professionals then push the market the other way causing liquidation of poorly planned positions. The same psychology applies to false breakouts of support or resistance levels, and we often see fakey setups form as breakouts from support or resistance fail to follow through, this is why it’s better to wait for the “real” breakout by trading the retracements BACK to the breakout level after the initial “real” break occurs….rather than trying to guess which break will be the real one.
Fakey’s also occur in trending markets as amateurs try to pick the top or the bottom. As a trending market stalls or consolidates for a few days, many traders will think it is ready to reverse, and convince themselves that a trend reversal is imminent (even though no valid PA setup is present). As the market initially breaks counter-trend the pros come in and enter the market on the pull-back because they see it as an opportunity to get a good entry price in the direction of the dominant trend, eating up all the weak orders and driving the market back in the direction of the trend.
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Implications
The implications of this article are that you should not trade just an emotion or feeling alone, you need to have a pre-defined reason to get into the market; a price action setup in the proper context or at the proper confluent place.
Pro traders are not buying tops or selling bottoms, nor are they trying to pick tops or bottoms on a regular basis. They avoid these trading pitfalls because they KNOW WHAT they are looking for; they have mastered their trading strategy instead of just trading on a “feeling” alone. This is not to say that pro traders don’t lose trades, because all traders do, rather it means that pro traders make money in the markets because they over-ride the potential emotional pitfalls of the market with logic, and this means not only mastering a trading strategy, but also not giving into the temptation to risk too much or over-trade. A pro trader may buy into a rising market or sell into a falling market, but only if there is a “setup” or a valid reason to do so, not just because they are excited by the price movement. Similarly, a pro trader may trade a top or bottom, but only because there was a valid counter-trend setup; not because they are emotionally trying to pick the top or bottom where no logical setup exists.
False-breaks form out of emotion; they form as a result of traders who trade without a valid reason or logic; not on what they see but on what they think. So, if we follow the guideline of master one price action setup at a time, and then trading only what we see and not what we think “should” happen, we should find success, assuming of course we are effectively managing risk and not messing around on the lower time frames.