How To Trade Breakout Retests In Forex
Breakout trading is one of the most utilized approaches in the Forex market. This is because trading breakouts is simple and far easier to implement when compared to other strategies, making it a great option for traders starting out and even veterans of the market.
Although breakout trading in itself can be implemented successfully, it is a psychological roller-coaster because the approach involves a very low win % but large gains (trust me it can lead to some headaches). So instead, we will tackle a variation of this approach and discuss how to trade breakout retests.
You may be wondering why breakout retests instead of pure breakout trading? Waiting for retests of levels after breakouts has a far higher win % and it is easier to find good stop loss points thus it is better for risk management. Before we dig deeper into the strategy, let’s address the basics.
What is a breakout?
Breakouts are aptly named, this is because it involves price breaking through a previous level of support or resistance. These support and resistance levels may be highs/ lows, historical inflection points, and even trendlines/ channels. However, to grasp the initial concept, this article will focus on horizontal breakouts.
What is a breakout retest?
Breakout retest refers to price breaking through a level of support or resistance, like in the above example, then price returning to the level that was previously broken. In a bullish breakout through resistance, the previous resistance now acts as support. In a bearish breakout through support, the previous support will act as resistance. Take a look at our previous bullish breakout example but with a retest to better visualize the concept.
As will all trading price is not guaranteed to go up like in the example, but traders will always be aware of buying power (demand) when price retests the level that was broken. The opposite applies to bearish breaks.
How to trade this strategy?
Breakout retest trading is about as simple as it can get. Here are the steps that you want to be following:
1. Identify key levels of support and resistance on the chart. These may be the current highs or lows in the market environment or significantly important historical levels. If you are still unsure about levels then check out our article on support and resistance.
2. Wait for price to break through the level of support or resistance. Do not trade yet! Be patient and disciplined in following this strategy.
3. Monitor and see if price returns/ retraces back to the level that was broken. Of course, it is not guaranteed that price will return, if there is sufficient force then price will continue in the breakout direction without returning. Do not be discouraged in these situations, follow your strategy and you will win in the long run. If you struggle with this then read more on trading psychology.
4. If price returns to the level then this is when you should start looking for confirmation signals that the trend should continue in the direction of the breakout. Keeping it on the simple our confirmation will be a strong candlestick in the direction of the breakout.
1. Place the stop loss past the level that was broken, when buying below the level of support and when selling above the level of resistance. Make sure to leave a buffer in case of spread or moves slightly past the level (since the level acts more like a zone). The amount of room given should depend on the timeframe being traded, it takes testing and experience to determine the best amount of leeway to give but as a default allow 10-20 pips of room.
2. Place the take profit at the next level of major importance where the market may halt, in a buy trade this would be at the next major resistance and with a sell trade it would be the next major level of support.
That’s all you require to trade this strategy, here are examples of setups for us to dive into.
On this daily chart of USDJPY you will see price break below a major level of support. The next step is to move to a lower timeframe to look for confirmation and enter the sell, take a look at the H4 chart of the same pair after the breakout.
The H4 chart shows that price retraced, provided and entry signal (confirmation) on the retest of the level (in the form of an engulfing candle). This trade worked out and went on to hit our take profit at the next major support level.
Next, we look at a bullish example starting on the Daily chart of USDCAD.
There is a major zone of resistance around 1.335 on USDCAD, buyers have found it difficult to break this level, but as shown buyers eventually succeed in lifting the price past the level. This means we should now wait on the lower timeframes for a retracement and confirmation that the buyers are strong. Below is the H4 chart after the breakout.
Price retraced and retested the zone, a Doji candle was followed by an engulfing candle which gave enough confirmation to initiate a buy. Price went on to hit the TP but continued even further and rallied over 1000 pips on Coronavirus fears. If you want to understand more about how fundamentals and news affect the market head to the fundamentals section.
Such is trading that no strategy will work all the time. Here on AUDJPY we have an example of the strategy producing a losing trade. First up, we will look at the H4 chart breaking the level and then the H1 for the entry and move against our position.
The chart tells a sad story, price would have moved against us and hit the stop loss before reaching the take profit, but that is a part of trading, it is key to manage risk so that these losses don’t hurt us too much psychologically or financially.
Study these examples and put in some chart time yourself to become familiar with the strategy and recognize these opportunities with ease.
Here are some important points that need highlighting before finishing up:
- Support and resistance act as zones instead of precise turning points, it is best to then think of them as an area that price could turn. Draw larger support and resistance levels on your charts to become familiar with this.
- After breaking out the market could fail to extend its move in the breakout direction, these are known as false breakouts. Waiting for a retest already helps protect against this, but this only helps if we manage risk correctly and wait for confirmation before entering.
It is essential to put in some chart time to recognize these opportunities as they occur. If tested and adjusted properly, breakout retest strategies can be simple but extremely profitable.
Put in the work and you will reap the profits.