How To Trade Breakouts In Forex
Breakouts are a great approach for Forex trading, why? Simplicity is the reason! The methods are structured and rule-based, which is what traders need to achieve consistent results.
I must be honest upfront, pure breakout trading does come with psychological challenges due to fake breakouts, and thus a lower win %. Some traders may be suited to trading breakout retests instead. All that being said, when implemented correctly, breakout trading can make consistent profits.
That is what we are here for right! Coming up is – The basics of breakouts, examples, a strategy to trade breakouts, as well as how to determine the strength of a breakout.
What is a breakout?
For this lesson, we will focus on trading horizontal breakouts, but it is important to realize that the concept of breakouts stays the same (no matter what the technical level is).
Bullish breakouts occur when price breaks through a level of resistance, bearish breakouts occur when price breaks through a level of support.
It is significant to a technical analyst when bulls and bears are able to break through important levels, as it shows a shift in the balance of supply and demand in the market (which is why breakout trading works).
Bullish breakout – GBPNZD H4
Bearish breakout – USDJPY H4
How to trade breakouts?
1. Identify key levels of support and resistance on the chart.
2. Wait for price to break through the level of support or resistance.
3. Enter if a candlestick closes past the zone on the timeframe that you are trading. This candle must represent strong buying or selling, when buying this would be a strong bullish candlestick past the resistance zone and when selling a strong bearish candle past the support zone. If you are unsure about how to judge the strength of candlesticks, then read this.
1. Place the SL past the broken level/ zone, buy trades would be below the previous resistance level and sell trades would be above the previous support level. Leave some room in case of spread and slight moves past the level on potential retracements.
2. Place the TP at the next major inflection point where the market could reverse against your trade. In buy trades, this would be at resistance, in sell trades this would be at support. Another possible TP placement could be at the price of a measured move e.g. if a range is 100 pips and price breaks out, the TP could be set 100 pips away.
Those are the key components of breakout trading. It would be a shame if I didn’t give some examples of it being implemented, here they come using the charts we looked at earlier.
Buy trade – GBPNZD H4
On GBPNZD price broke through the level and traded sideways for a few candlesticks, then a bullish candle printed far away from the zone. This candlestick was not the strongest, however, it closed far past the resistance level showing demand.
When the candlestick closed you would enter a buy position, with the SL below the former resistance level and a TP at the next major resistance (visible on the Daily timeframe)
Sell trade – USDJPY H4
On USDJPY, a strong bearish candlestick broke through the support level, the candlestick closed near the low which represents a strong signal to enter a sell trade.
As soon as you placed the sell trade, the SL would go above the previous support level and the TP would be at the next major support (visible on the Daily timeframe)
How to determine the strength of a breakout
I mentioned at the beginning of the article that breakout trading can have a low win % due to false breakouts (also called fake-outs). To reduce the chances of trading false breakouts, you must consider the validity and strength of the signal, here is what you should look out for.
- Two points that have already been made. First one being, broken levels must be significant, without this a breakout does not indicate a shift in supply and demand. Secondly, candlesticks should be used to time entries and validate the strength of the bulls or bears.
- Volume is a great tool for breakout trading, a breakout on low volume is invalid because it indicates a lack of momentum, conversely, high volume adds extra confirmation to the trade.
- When price moves through a level will strong momentum, i.e. without hesitation, this is a sign of strength. Should wicks be present on candlesticks or the market moves sideways, the breakout is not as powerful.
Now that you have the low-down on trading breakouts, test it for yourself, and find if this approach suits you. What I discussed was the bear bones of implementing this method successfully, you will find ways to improve the results through testing and practice.
The rules presented can be implemented to focus on reversals or continuation of trends, whatever you desire.
If you want to start trading breakouts today, open a demo or live account with FXCM and get going.
Put in the work and you will reap the profits.
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