Trading Trendline Breaks
Trendlines are a form of dynamic support and resistance which means trendline breaks signal a potential shift supply and demand, just as breakouts of horizontal levels do. Traders can take advantage of these occurrences and position themselves on the correct side of the market.
Before we rush, what is a trendline breakout? This occurs when price closes past a trendline that previously acted as support or resistance; in a downtrend, this would be price moving above a downward sloping trendline (bearish trendline), in an uptrend, price would have to move below an upward sloping trendline (bullish trendline)
If you want to learn more about trendlines themselves I would suggest reading this article.
What does a trendline breakout look like on a Forex chart?
Trendline breakout- GBPAUD H4
The bearish trendline was respected as resistance until price broke above it, the opposite applies to an uptrend.
Two predominant ways to trade breakouts are usually implemented in Forex Trading- Trading the pure breakout or trading the breakout retest.
Ways to trade trendline breaks
What does it mean to trade the pure breakout vs the retest? Executing on the pure breakout means you would enter as soon as the market moves/ closes past the trendline; trading the retest means after price breaks through, you wait for price to retrace back to the trendline and use the support/ resistance zone to open a position. More on this when the strategies are discussed…
Before unveiling the two approaches you need to determine which you may prefer, here is what should be considered.
Implementing a pure breakout approach would likely lead to a lower win % (due to false breakouts) but you will miss fewer trends (executing on the breakout leads to more positions)
Waiting for retracements should result in a higher win % (less false breakouts), however, you could miss large trends often (strong momentum moves may not retrace)
Both come with advantages and disadvantageous, it is your job to think/discover which suits your personality.
Pure trendline breakout strategy
Trendline breaks are great indications of the fight between bulls and bears, usually, when a trendline is breached it means that the opposite side of the market is in control. This is why trading these occurrences can be so profitable.
1.Firstly, a trendline must be drawn connecting major swing points; in an uptrend higher lows are used, in a downtrend lower highs are used.
2.Wait for price to close past the trendline on the relevant timeframe i.e. if you are trading on the Daily then the market must close above/ below on the Daily.
3.Enter the relevant position (buy trade for a bearish trendline breakout, sell trade for a bullish trendline breakout)
1.Place stop loss (SL) well below the trendline in buy positions and well above the trendline in sell positions.
2.Take profit (TP) is placed at the beginning of the previous trend (that is being reversed) i.e. the swing high or low where the trend began.
3.Trailing stop techniques can also be implemented since the market will not always return to the beginning of the previous trend.
Example of the strategy
Breakout trade- NZDJPY H4
If a bullish trendline is broken, a sell trade would be executed.
Trendline breakout retest strategy
Retests are based on the fact that once broken, previous resistance becomes support and previous support becomes resistance. By waiting for the added confirmation of a support or resistance level, you can have a higher win %.
1.Draw a trendline connecting major swing points.
2.Wait for a break of the trendline on the timeframe you are trading.
3.If price retraces and touches the trendline, prepare to enter a position; in a buy position, this would be a retest of a downward (bearish) sloping trendline, in a sell position, this would be a retest of an upward sloping (bullish) trendline.
4.Should the market print a confirmation candle then enter a position; bullish candle for a buy and bearish candle for a sell.
The exit and risk are managed the same way as the pure breakout strategy.
Example of the strategy
Breakout retest trade- EURNZD H1
The opposite of the above occurrence applies to buy positions.
In both strategies, it is important to remember that trendlines are subjective meaning they have a zone of influence instead of exact points.
How to reduce the chance of false breakouts
False breakouts refer to occasions when the market does not extend its move after breaking through support or resistance. These cannot be avoided completely but there are ways to reduce the chances, including the following:
- Waiting for confirmation- Achieved by only placing trades when a candlestick shows our side is strong. With the pure breakout strategy, we want at least one candle to close strongly past the trendline; with the retest strategy, we want a strong candle to print soon after the test.
- Checking the volume- False breakouts are known to occur on low volume, therefore, a good confirmation technique is checking that volume increased or stayed relatively the same as price broke through.
- The momentum of the move- If the momentum of the price move was strong before and during the breakout, there is a greater probability of continuation.
- Importance of the trendline- Although our trade examples show 2 inflection points, 3 inflections or more confirm that a trendline is strong. As mentioned trendlines are subjective, so it is safer to connect trendlines at high/ low prices (instead of open/close prices or other points) since more participants pay attention to these prices.
Swing points- AUDUSD Daily
AUDUSD uses high prices as the trendlines’ anchors and connects 3 points, both of which enhance the strength/ importance.
Before closing I want to mention something mind-blowing, ok maybe not that mind-blowing, but… You may think that trendline breakouts are for reversals only, not true! Trendlines can be drawn on smaller timeframes, and subsequent trendline breaks can be traded with the larger timeframe trend. Amazing!
Trading with these strategies does take practice and adjustment, but put the work in and…
An abundance of profit can be yours.