What is a breakout Strategy in Forex?
A breakout forex strategy involves capitalising on the sudden bullish or bearish price movement a currency pair makes as it breaks out from a holding-ranging trading pattern—a pattern that typically exists between support and resistance levels.
Here we’ll discuss the basics and the mechanics of a breakout strategy and the most straightforward techniques you can assemble to take advantage of the breakout phenomenon. We’ll also provide some suggestions to put the trading theory into practice.
When forex breakouts occur and how to identify them.
Breakout trading strategies are popular with day traders, who look to profit from movements related to breaking news or the daily events listed on the economic calendar.
Forex breakout patterns occur on our charts in various guises and for several reasons, and increased volume and volatility are vital to the identification process. So, let’s discuss five identification methods and causes.
- Support, resistance and other levels
- Chart patterns
- Market consolidation
- News releases
- Technical indicators
Price can test or breakthrough critical support and resistance levels, and the currency pair price can also test Fibonacci retracements and other technical indicators. Such areas are where institutional market orders can cluster. When price responds to, breaks or pushes through such levels or indicators, a breakout could be occurring.
Chart patterns also get used to find breakouts. Flags, pennants and candlestick patterns are popular patterns used to pinpoint breakouts.
A consolidating market, as investors and traders hold their positions, cannot last forever. Eventually, the price will break out of the holding pattern. The probability of price breaking out of a range increases the longer the holding period lasts.
As the trading range narrows, volumes usually decrease. Price can get driven up or down if and when participants come into the market.
The scheduled release of an official economic report or market-related data can catalyse a move. Similarly, if an unscheduled news event breaks, the price of a currency pair can suddenly react.
As mentioned above, increased trading volume and volatility can also be the precursor of a potential breakout or an indication that it’s in progress. And several technical indicators illustrate the phenomenon.
Stochastics, the OBV (on balance volume) and the Chaikin Money Flow are three examples of helpful volume indicators. The volume theory is simple; if the volume of orders and activity in a market suddenly increases, then the likelihood of a sharp bullish or bearish movement rises.
Bollinger Bands, ADX, and the ATR (average true range) are examples of volatility indicators. The ATR’s use is perhaps the most logical. The ATR will show the movement if the currency pair’s price moves out of its earlier trading range and into a trending mode.
A combination of volume and volatility indicators (with essential price action pattern recognition) together with simple drawings on your charts such as channels, wedges and trendlines, could build a credible breakout strategy.
What are the best breakout strategies?
Trading can be a subjective process; what works for one trader might be unattractive to another. You also must remember that breakout strategies are more appropriate for traders who trade off lower timeframes such as scalpers, day traders and swing traders because the breakouts are more visible and dramatic on lower time frames.
Many mentors would suggest keeping the process simple and finding wedges or channels while studiously observing where price moves concerning support and resistance can prove valuable to profit from breakouts.
Session open breakout strategies are widespread amongst many traders. For instance, although the FX market is a 24 hrs a day market on specific days, the London market open is carefully watched by FX traders because The City of London is still considered the centre of FX trading. Therefore, many major currency pairs’ directions get set during the London – European session and when the FX market opens.
FX traders may look at the price just before the 8 am open, set a stop loss, a profit limit order, and enter the market short or long, depending on what they judge to be the underlying sentiment. And the complete process can be fully automated if you set an entry point, long or short.
Is breakout trading reliable?
Breakout strategies can be one of the most reliable and profitable trading methods. In some ways, breakout trading is the very essence of retail forex trading.
If we accept the trading wisdom that FX markets range 80% of the time and only trend 20%, then it’s during that trending period (the breakout and its effect) when we’re most likely to bank profit.
So, suppose we take this logic a stage further. In that case, you could argue that developing a breakout trading strategy with an edge and positive expectancy is imperative to your potential success. And the method/strategy should work if you apply it correctly.
What are the best time frames to trade breakouts?
It’s a subjective choice depending on your trading style. Breakouts can happen at any time; therefore, you need to keep well-informed of breaking news possibilities by way of your economic calendar.
So, if you’re a day trader who’s looking to trade potential currency pair breakouts when the session opens, you need to be primed and ready to act.
Trading session open breakouts off smaller time frames, perhaps as low as 15-minute TFs, could be the right choice as you’ll see the price action developing. Such
If you’re a swing trader, you might prefer to make decisions from a time frame such as the 4hr. However, the danger is that you lose the ability to zero in and magnify the appearance of the actual move.
Let’s not forget that although the breakout might herald the beginning of a new trend, that trend may be short-lived, and the initial breakout move may be the only opportunity to profit.
Do you need indicators to trade breakouts?
We previously highlighted some technical indicators that could help pinpoint breakouts. Rather than apply a combination of these, you could opt for a simplified approach.
Price action (PA) could be regarded as the principal method to identify breakouts. If you then combine PA with carefully selected technical indicators, you’re most likely giving yourself the best chance to succeed.
The basic mechanics of a breakout strategy
Profiting from breakout strategies requires you to concentrate on precise entries while using stop losses. Therefore, it would be best to decide whether to have a take profit limit order in place and decide on an exit strategy before entering the market.
A breakout is any price movement that typically happens outside of a support or resistance area. As a rule, the longer a market consolidates, the more volatile the resulting breakout.
There are three/four parts to basic FX trading breakout strategies, and we look to identify these critical areas on our chart:
- Support
- Resistance
- Breakout
- Retest
If price tests and retests support or resistance levels, it’s a signal that provides traders with opportunities and motivation to enter the market. Such movements would suggest that the currency pair’s price is getting set to break out of a range.
However, if the market moves sideways for several periods following an initial breakout, the market might not produce a retest of support or resistance or, finally, breakthrough and breakout.
You must carefully consider where to place your stop loss. If you’re looking to go long, perhaps the recent low of the ranging channel would be a helpful gauge. If you’re looking to short the market, the opposite is true; look for the recent highs.
An example of a simple breakout trading strategy
A suggested method/strategy could look like this if you were hoping to capitalise on a bullish movement caused by a calendar event beating economists’ expectations.
You would use the candlestick patterns, the daily pivot point, resistance levels, and a moving average, and your decisions get executed on a 30-minute timeframe.
So, how do we tie it all together? We wait for bullish price action illustrated by two filled bullish candles. We also see that price has moved above the daily pivot point and is threatening to breach or has already breached R1 or R2 (the first levels of resistance).
We can also see that price is trading above the 14-day EMA (exponential moving average). Such an exponential MA often shows prices moving aggressively away from the mean and the earlier range.
This simple method and strategy should ensure you don’t trade against the short-term daily trend when a potential breakout occurs. If you then place your stop-loss order close to the daily low and make a judgment about a take profit limit order, then you’re using the type of simple breakout strategy that many traders favour.
And don’t forget, simplicity is vital with breakouts because you might not get too much time to decide and execute your trade. Therefore, it might be worth setting the alarm to ping you if the price reaches a certain level.
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