What Are Failed Breakouts And How You Can Take Advantage Of It

If a breakout sends a stock higher, failed breakouts will often send the stock lower very fast. This can be a great shorting opportunity for traders. If you do not know what is a breakout I highly recommend that you go through this article What Is A Stock Breakout? Once you have gone through the article, you will have a greater appreciation of failed breakouts.

A successful breakout in stocks or an index will usually send it higher. Sometimes, the breakout will take the stock into new territories that the stock has never been through. A successful breakout might send a $50.00 stock flying up to $100 in a few months time. Do not be surprised by this. 

On the other hand, a failed breakout is a failed expectation and this often sends the stock going south. It is not uncommon to see stocks lose 50% of their value over a few months thanks to a failed breakout. Since stocks can fall when expectations are not met, the astute trader can short a stock that experiences a failed breakout and make some nice fast gains.

failed breakout

The chart above is a good example of how a failed breakout looks like. SPY was consolidating nicely and many traders and investors were expecting the index ETF and the S&P 500 index to breakout and move higher. The SPY broke out and moved higher by just a little bit. This gave hope to breakout traders and many people thought it was going higher. However, SPY failed to follow through to the pattern.

The failure to follow through crashed the expectations of many market participants and it immediately send SPY crashing lower. Breakout failures can often send a stock or index going lower extremely fast. A very sharp trader will take the opportunity to short the index or stock for some fast gains.

The fall did not last long because there was ample support below. Thus, the SPY rebounded higher very quickly. But it was enough time, a day or two for traders to make some nice gains.

How To Short A Failed Breakout

breakout failure

Costco also had a failed breakout which send it lower. From July to August 2016, the stock had a very nice consolidation which set it up for a possible nice breakout. The stock went higher a little bit but failed to hold its gains. It drifted sideways once again and then broke below the consolidation.

The failure to breakout changed the mindset of many market participants from bullish to bearish. Failed breakouts will nurture failed expectations. When expectations are not met in the stock market, it often sends a stock lower.

Which explains why many stocks will drop and crash even when they report good earnings. An investor who was expecting a company to make a profit of $500 Million will be disappointed to hear his company made only $400 Million in profits. The failed expectations will send the stock lower even if the earnings report was good for the company.

Coming back to the failed breakout in Costco, when COST failed to breakout, this send some warning signs to traders. Once it broke below the consolidation, it gave traders a signal to short the stock. Take a look at how much the stock has fallen.

How do you enter a short position in a failed breakout? :

  1. First of all, make sure there is a consolidation
  2. Then make sure there is a failed breakout
  3. When the stock drops below the consolidation decisively, you short it
  4. Put a stop loss at the top of the consolidation

A failed breakout short can often give traders a 3 to 1 reward to risk. The gains can also be very fast because stocks tend to fall 3 times faster than it rises. One thing you need to take note of is support below. If there is lots of congestion and strong support below, you should cover the stock when it reaches the area. At least cover half of it and see if the stock can go lower.

The chart above is another example of how a failed breakout can send a stock lower. Fastenal Company had a really nice consolidation which sets it up for a nice breakout. The stock tried twice to breakout higher but it failed to do so. One day, the stock gap way below the consolidation area. A trader who observed this could have shorted the stock and ride the wave lower.

What if you were holding this stock?

When your stock consolidates and experiences a failed breakout, you should consider selling some of your shares because you never know how low your stock can go. Take note of any support areas below. If there is no good support below, then you should definitely sell at least half of your shares.

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