The breakout strategy has seen many people become successful forex traders.
This means that it’s a technique worth mastering as a forex trader.
Traders use it to enter the market during the early stages of a trend.
It can mark the starting point for major price moves and expansions in volatility.
If a trader manages it properly, it can provide a limited downside risk.
Although it sounds simple, a lot is involved when using this trading strategy.
The trader must learn how to identify price trend patterns as well as the support and resistance levels so that you can plan your entry and exit points well.
You also need to know how to cut your losses and re-assess the situation in case the breakout sputters.
The trader must also be in a position to distinguish between real and fake breakouts.
In this article, I will help you know how to trade using the breakout strategy.
What is the Breakout Strategy?
A breakout is said to have occurred when the price of an asset manages to move above a resistance area or below a support area.
Breakouts act as a signal that there are high chances for the price to continue trending in the direction of the breakout.
If a breakout occurs to the upside on the chart pattern, it can be a signal that the price will start to trend higher.
If the breakout occurs at a high or normal volume, it’s a signal that the price is most likely to trend in that direction.
This means that the volume indicator is an important tool when using this type of trading strategy.
It is worth noting that breakouts are subjective because all traders will not choose to use the same support and resistance levels.
The process of selecting support and resistance levels is subjective, hence, different traders will choose different positions for these on price charts.
They provide traders with possible trading opportunities.
If a breakout occurs to the upside, it’s a signal that traders should enter long positions or exit short positions.
If the breakout occurs to the downwards, it’s a signal that traders should enter short positions or exit long positions.
If the breakout occurs at a time of a low volume, it is more likely to fail, meaning that the price is less likely to trend in the breakout direction.
What a Breakout Tells Traders
A breakout occurs because the price of the forex pair in question has remained below a resistance level or above a support level for some time.
Traders then use the support and resistance levels to set the entry and stop loss levels.
After the occurrence of a breakout in the market, traders who were waiting for the breakout to occur jump into the market while those who didn’t want the breakout to occur exit their positions immediately to avoid making losses.
Such a flurry of activity will cause the volume to increase, which indicates that many traders were interested in the breakout level.
A higher than average volume acts as a confirmation of the breakout.
If there is a little volume during the breakout time, it means that the breakout was not significant to most traders, or very few traders were convinced to enter trades at the breakout level.
Such breakouts do not normally go far.
If the breakout was to the upside, the price will fall back below the resistance line.
If the breakout was to the downside, the price will rise back above the support line.
Breakouts are mostly associated with ranges and other chart patterns such as flags, triangles, head and shoulders, and wedges patterns.
Such patterns are formed when the price moves in a particular way creating well defined support and resistance levels.
Traders normally watch these levels for breakouts to occur.
If the price breaks above the resistance level, the traders may exit short positions and enter long positions, while if the price breaks below the support level, the traders may exit long positions and enter long positions.
Even when the breakout occurs at a time of high volume, the price may make a retracement to the breakout point before it can continue to move in the direction of the breakout.
The reason is that short-term traders will normally buy the initial breakout, and the try to sell quickly to gain profit.
The selling activities of the traders will send the price of the forex pair back to the breakout point.
If the breakout is legitimate as opposed to being fake, then the price will move back in the breakout direction.
If the price doesn’t, it will be a failed breakout.
Traders who trade based on the breakout strategy use stop loss orders to protect their trading accounts in case the breakouts fail.
If the breakout occurs to the upside and the trader goes long, the stop loss should be placed just below the resistance level.
If the breakout occurs to the downside and the trader goes short, the stop loss is placed just above the support level.
If the market makes a reversal and begins to move against the trader, the stop loss will be triggered and the trader will automatically exit the trade.
This will protect the trader’s account from being wiped out, which can be a devastating loss.
Let’s have a look at the common breakout patterns that occur in forex…
In the above figure, we have a market that is trending upwards but it finds resistance at a horizontal level.
The price made two attempts to break out through the resistance line unsuccessfully.
However, the price managed to breakout through the resistance level on its third attempt.
So, this acts as a signal for a bullish breakout from a key resistance level.
Traders can take advantage of this to enter long positions.
A closer look at the figure shows that the price did not come back to retest the key resistance level as a support level.
In some cases, the price will come back to do a retest.
If the price bounces back and moves upwards, it will be a signal that the current bullish move is very strong.
Consider the following figure…
The above figure shows the formation of a bearish breakout.
It is similar to the bullish breakout, but the breakout occurs to the downside.
The price attempted to breakout through the support line twice unsuccessfully.
However, this was successful on the third attempt.
So, this is a signal of a bearish breakout from a key support level.
Such breakouts are an indication of an increased volatility in the market, hence, they are very important to traders.
If you wait for a break of a key level, you can use the volatility in your favor by joining the new trend as it begins.
A closer look at the figure shows that the price came back to retest the support line as a resistance line.
The price bounced back and begun to move downwards.
This is a signal that the bearish trend is very strong.
Components of a Forex Breakout Strategy
This trading strategy is well known for its high reliability and the fact that it gives more than favorable risk to reward ratios.
Here are the components of the breakout trading strategy…
Consider the following chart…
In the above chart, we have two trend lines.
One of the trend lines is acting like support, while the other one is acting like resistance.
These two trend lines have led to the formation of a wedge chart pattern.
A breakout will be formed when the market manages to breakout in any of the directions.
A wedge acts as a continuation pattern, and you should trade it based on the direction of the breakout.
So, it will be good for you to let the market show its hand before you can make any consideration in terms of the future price movement.
In the above chart, as the market begun to consolidate tighter, it managed to break the wedge support.
However, it retested the wedge support as a resistance level.
The retest provided traders with a perfect opportunity to enter short trades.
Notice that the retest was followed by a bearish move.
Traders who had entered short positions will make profit from the bearish move.
How to Execute the Forex Breakout Strategy
It will be good for you to know how to trade this strategy appropriately.
This involves knowing when to enter into trade, where to set the stop loss, where to set the profit target, as well as when to exit the trade.
Let’s discuss these…
In most cases, the best time to enter a trade will be when a retest occurs on a former support or resistance line.
However, it’s of great importance for you to note that the retest may never occur depending on the strength of the market trend.
Whether to enter a long or short trade will be determined by the way the market breaks out.
If the market breaks through the resistance line upwards, you can enter a long position by buying the forex pair.
If the market breaks through the support line downwards, you can enter a short position by selling the forex pair.
Even though a breakout has occurred, you are not sure whether the trend will continue for long.
In case the market makes a reversal, you can incur a loss.
A stop loss is a good risk management strategy because it will help you exit the trade once the market begins to move against you.
If the price breaks out through the support line downwards, place a stop loss order above the candle that broke the support.
Consider the chart given below…
The above chart shows when to enter a short position and where to set a stop loss after the price of a forex pair breaks out through the support level downwards.
The right time to enter the market has been marked as Go Short.
This was after the price had retested the previous support line as a resistance line and begun to move downwards.
The position of the stop loss has been marked as Stop Loss.
The stop loss has been placed just above the bearish candle that managed to break through the support line.
If the market makes a reversal and begins to move upwards, this stop loss will be triggered and you will immediately exit the trade.
This will protect you from incurring a loss.
Also, notice that the stop loss has been placed some pips above this candle.
The reason is to prevent the stop loss from being triggered unnecessarily.
Price consolidations normally occur in the market, especially as a result of profit taking activities of the traders.
Such consolidations can trigger the stop loss unnecessarily, meaning that you will exit the trade prematurely and miss out on making profits.
So, always set the stop loss some pips above the breakout candle.
You now know when to enter the trade as well as where to set a stop loss.
It’s now time for you to know where to set the profit target.
You can use simple price action levels to determine the ideal place to set your profit target.
Consider the following chart…
The above chart shows the ideal time to exit the trade when using the breakout strategy.
The exit point has been marked as Exit Here on the price chart.
To determine the exit point, we have used a support level.
What you notice is that the support area is very strong and that it has been in place for a very long period of time.
This makes this area an ideal place for you to set your profit target.
To determine the risk to reward ratio that you will get from this, you can do a simple math.
You simply have to divide the number of pips between the entry point and the exit point by the number of pips between the entry point and the position of the stop loss.
Example of a Breakout
Consider the chart given below…
The above chart shows the occurrence of a breakout to the upwards at a time when there is a high volume in the market.
Note that the breakout has occurred through the resistance line, the upper black line running horizontally on the chart.
The position of the breakout has been pointed to by the black arrow on the chart.
After the occurrence of the breakout, the price never came back to the original breakout point, but it instead continued to move upwards.
This means that the breakout was very strong.
Traders could have used the breakout to enter long positions or exit short positions.
After entering a long position, the trader should not leave his trade naked, but he should protect it using a stop loss.
The ideal place to place a stop loss in this case is just below the resistance level.
Consider the following chart…
The above chart shows where you should place your stop loss when trading the bullish breakout.
The stop loss position has been shown by a red horizontal line marked as Stop Loss on the chart.
However, the best risk management strategy in this case is to use a trailing stop loss.
This is a type of stop loss that shifts its position once the price moves in a direction that favors you.
In this case, the price continued to move in a favorable direction for buyers.
So, the use of a trailing stop loss would have ensured that more profits are locked in as the bullish move continues.
This could have seen the trader make a huge profit.
How to Avoid False Breakouts
There is a considerable number of forex breakouts that fail.
Such types of breakouts are referred to as false breakouts.
This forms the biggest downfall of the breakout strategy.
When a false breakout occurs, most traders are caught on the wrong side of the market.
If the traders had not protected their trades using risk management strategies like a stop loss, they incur huge loses.
One of the ways for you to distinguish a breakout from a false breakout or a fakeout is by waiting for a confirmation.
For example, fakeouts occur when the price opens beyond a support or resistance level, but by the end of the trading day, the price winds up moving back within a prior trading range.
If a trader decides to act too quickly or without a confirmation, there isn’t a guarantee that the prices will continue into new territory.
Many traders rely on above-average volume as a confirmation or wait towards the close of a trading period to know whether prices will sustain the levels they have broken out of.
If the price manages to sustain the levels, then the breakout is real, otherwise, it is a fakeout.
Consider the following chart…
The above chart shows the occurrence of a false breakout on the price chart of a forex pair.
The price severally tries to breakout upwards through the resistance line but it fails.
The resistance line is the red line running horizontally across the chart.
The price finally managed to breakout through this line upwards.
Due to this, most traders will interpret this as a bullish breakout from the resistance level.
Due to this, they will enter long positions by buying the forex pair.
This point has been pointed to by a green arrow marked as Buy Here.
However, the price chart shows that the bullish trend did not continue for long before making a reversal.
Although the price could be retesting the former resistance line now become support, this was not the case.
Instead, the price made a breakout through this level and continued making a bearish trend.
All the traders who had entered long positions after spotting the bullish breakout in the market are now caught on the wrong side of the market.
So, it was good for the traders to wait for the retest to be successful before jumping into long positions within the market.
If the price bounced back and begun to make a bullish trend after the retest, that would have been the best time for the trader to enter a long position.
The trader could also have looked at the volume indicator to know whether the breakout is real or a fakeout.
A closer look at the volume indicator during the occurrence of the breakout shows that the volume was low and probably decreasing.
This is a wakeup call for the trader to be cautious before jumping into a long position.
You also need to learn to read the price action context.
That way, you will be in a better position to find the key support and resistance levels at which there is so much order flow around that level.
Limitations of using the Breakout Strategy
The major problem that traders who use this trading strategy face is failed breakouts.
The price will just move past a support or resistance area, luring traders to jump into the market in the direction of the breakout.
However, the market makes a reversal and the price stops moving in the breakout direction.
This can happen multiple times before a real breakout occurs.
Also, the subjective nature of choosing support and resistance levels is also a problem to most traders.
That’s why you should combine the price breakout with volume.
The forex breakout strategy is a great way for one to become a successful forex trader.
However, the trader must be capable of identifying the breakout setups correctly.
This is possible using the support and resistance levels, even though they are subjective.
A breakout that occurs at a time of high volumes acts as a signal that the breakout is real.
A breakout that occurs at a time of low volume acts as a signal that the breakout is most likely fake.