What is the danger zone?

The danger zone is an area just outside the established price range of an asset. When support and resistance levels are suddenly broken, this area is where the competing interests of market participants meet.

Some participants want a breakout to occur, and make transactions in that direction, while those who expect the range to continue trade in the opposite direction. Stop hunters try to push the price into the danger zone to trigger the stops in that area, while others wait for the momentum to ebb before aggressively trading.

In the danger zone, prices are very volatile as triggered stops result in selling more aggressive than the previous buying (or buying more aggressive than the previous selling, in a falling market). This can result in gapping, which may lead to traders’ positions being closed at a worse level than where they set their stops.
However, traders can use this to their advantage.

Working the zone

By being informed, traders may be able to capitalise on speculation-driven breakouts that have failed.

For a breakout to fail, it must move back through the original breakout point. In the case of a rising market, a true breakout will have broken through resistance, and that resistance level will then act as support for the pullback. If it fails to act as support, it signals a short-term failure of the breakout. The same holds true in a falling market.

Therefore our first signal is a move outside the established range, which then retreats back into the range.

If you were trading forex, for example, the EUR/USD pair might be ranging between 1.4250 and 1.4445. Every time it approaches the 1.4250 level it starts heading up, and every time it approaches the 1.4445 level it starts heading down again.

Then it breaks through the 1.4445 level, hitting a high of 1.4500 before falling again. In that session it falls back to 1.4390, and continues trading between 1.4395 and 1.4415, so we can see that the original resistance level of 1.4445 has not become the new support.

The next day it hits a new high of 1.4530. At this second breakout, we go short, selling one contract on the EUR/USD in anticipation that the price will fall back to its original range. We place a stop just above the new high and we can either use a trailing stop to exit the trade, or set a profit target in the previous range.

The pair falls, returning to 1.4390 before trading between that level and 1.4425.

The next day it hits another new high of 1.4585. We open a position at the new high, knowing that when the market has fallen back below that price it is likely to keep falling. Again we place a stop just above the high, and use either a profit target or a trailing stop to exit the trade. Again, the forex pair falls, this time hitting 1.4350 and then trading between 1.4250 and 1.4400 over the next few days.

The formation of this pattern is that each high tops a former high, but collapses just as quickly into the former range. That being said, this strategy will not be effective unless there is already an established range.

Separating the true and false breakouts

Traders need to wait and see whether the breakout is a true breakout, which will hold and form a new range outside the previous support or resistance level, or a false breakout, which will quickly return to the established trading range.

Two good ways to evaluate this are:

1.    Volume – increased trading volume before a breakout increases its potential to maintain new price levels, particularly on upside breakouts. Light volume means that the breakout is more likely to fail as stops being triggered will increase the volume of trades in the opposite direction, meaning that the initial momentum is unlikely to last.

2.    Divergence – a relative strength indicator can also be used to signal that a reversal is probable. If the RSI is failing to make new highs as the price continues to rally, this is a confirmation that the breakout has a good chance of continuing.

False breakouts occur all the time and traders can either be on the winning side or losing side of them. When an asset enters the danger zone, it is time to watch for signs of weakness. When they appear, the trader simply needs to open a trade in the opposite direction of the breakout, setting stop losses and profit targets at risk-to-reward ratios in line with their trading system and objectives.