Think back to your last vacation. As you secured the front door and made your way to the car, you might have stopped to check the lock one last time before heading out.
Financial markets are driven by a wide array of human emotions, and they often demonstrate comparable tendencies. After an asset convincingly breaks through a long-standing resistance level, it usually retraces to reaffirm the breakout’s validity. This action serves as a test of the strength of the former resistance now acting as support; subsequently, larger rallies can emerge.
The concept of the “breakout and retest play” is familiar across various asset categories. Bitcoin’s (BTC) current decline could be interpreted as a healthy retest of the breakout level, specifically the previous resistance-turned-support at $73,757 that was surpassed in November.
In essence, the downward trend may lose momentum as it approaches these zones, potentially paving the way for a more substantial upward movement.
During this month, BTC has decreased by over 15% to below $80,000, revealing the previous resistance that has now turned into support at $73,757. This price level was breached in early November after a pro-crypto Donald Trump won the U.S. Presidential election, culminating a lengthy period of price consolidation.
The tendency for markets to pull back or revisit breakout levels prior to embarking on larger rallies is rooted in the psychological aspects of investing.
Investors are typically risk-averse when it comes to taking profits. As such, traders often secure their gains quickly, instead of letting profitable trades run longer. This behavior aligns with prospect theory, which helps explain why rallies following a breakout can suddenly stall, leading to a retest of the breakout price. Since December, BTC holders have been taking profits around the $100,000 mark.
Now, as prices decline toward the breakout threshold of $73,757, those who missed the initial price surge may rush in, lending support to that level. The following rebound from this former resistance-turned-support attracts more buyers, creating the potential for a significant rally.
This pattern was observed in the third quarter of 2023 and again in August-September 2020.
In both instances, the breakout and subsequent retest led to significant rallies culminating in new all-time highs. Nonetheless, traders should remain vigilant, as a failed retest or an absence of a significant rebound can signal underlying weakness, which might lead to a prolonged downtrend.
Throughout the years, I have witnessed numerous instances of retests of breakouts and breakdowns facilitating larger movements in traditional markets.
For instance, the yield on the 10-year Japanese government bond exhibited a double-bottom breakout in January 2024 and revisited the breakout point several times before climbing to multi-year highs.
Moreover, the AUD/USD pair broke through a significant support trendline in December, signaling a potential deeper decline. The pair rebounded to the trendline resistance earlier this month, only to experience severe losses recently.
