trading-breakout

If you have ever been in a trade when the price broke out of a long-standing resistance or support level, you must have seen how fast the price moves and how easy it was to make money.

Trading breakouts can actually be very exciting if you’re in the right direction — riding the surge like an ocean wave.

But if you’re on the wrong side, breakout trading can be a real pain. And, you may have experienced that — entering a trade on the breakout of a support or resistance level and, a few periods later, watching the price do a full U-turn on you and knock you out.

Though it contradicts the basic market dogma — buy low and sell high — the concept of breakout trading is nothing new to traders, as many have been using it over the years. A good example is the famous Turtle Traders trained by Bill Eckhardt and Richard Dennis

There are many breakout strategies used by forex traders, and in this post, we will show you how successful traders trade breakouts. But what exactly does breakout trading mean?

What is breakout trading?

A breakout is said to happen when a price bar closes beyond an established support or resistance area — which could be a horizontal level or a trend line, depending on the market structure and the patterns you can see on the chart.

As you may already know, especially if you have been reading our previous posts, trend lines are nothing but ascending support levels and descending resistance levels.

Thus, when the price climbs above the upper boundary of a ranging market (resistance zone) or falls below the lower boundary (support zone), the price can be said to have broken out of the range, which is also a rectangle chart pattern.

The same is true for most other chart patterns — triangles, wedges, flags, and pennants — which may have horizontal or diagonal (trend line) boundaries.

In fact, all chart patterns, including head and shoulder/inverse and double top/bottom involves one form of a breakout or another.

Furthermore, the price climbing above a previous swing high or falling below a previous swing low can also be said to be a breakout because the price is breaking a previous resistance or support level.

Breakout trading simply means entering your trades when the price breaks above a resistance area or below a support area to capture the expansive price movement that occurs beyond that level.

It literally means buying high with the hope of selling higher in an up-trending market or selling low to buy lower in a downtrend, which is contradictory to the conventional market principle of buying low and selling high.

Despite the contradiction, breakout trading does work on many occasions. But why would someone wish to buy high and hope to sell higher or sell low and hope to buy lower? The answer is simple and of two folds : 

-The market can trend, and a breakout may signal the emergence or continuation of a trend.

-Breakout trading implies entering a trend that is already in motion, and one of the tenets of technical analysis is that a trend in motion is more likely to remain in that direction than reverse

There is also a third answer : many legendary traders and market wizards, from Jesse Livermore and Ed Seykota to Richard Dennis and Bill Eckhardt, used some form of breakout strategy.

Probably the most popular use of a breakout strategy was that of the Turtle Traders experiment, where Bill and Richard taught some newbies a trading method that included the use of breakouts.

Those traders, called the Turtles, went on to achieve about 80% compound rate of return.

But even with all the supporting factors, breakout strategy is not a holy grail — of course, there’s never one. A lot of breakouts fail almost immediately.

As a matter of fact, there are more false breakouts than genuine ones, but if you capture a genuine one, you can get a nice reward for it.

Types of breakouts to avoid

Nobody wants to get caught up in a false breakout. When you get trapped in a false breakout, buying the high or selling the low will feel like the most stupid thing to do. 

While there are a lot of false breakouts, there may be a way to filter out the breakouts that are likely to fail. Here are a few examples of breakouts that are more likely to fail than work :

Against the trend

Trading against the trend has always been considered very risky, and breakout trading is not an exception. 

A breakout against the trend is likely to fail because it is still a pullback move, which is generally weaker.

It is not uncommon, in an uptrend, for a pullback to break below a support level, lure sellers in, and, later, turn back to continue climbing higher.

Similarly, a rally, during a downtrend, can break above a resistance level, trap the early bulls, and turn back to resume the decline.

Although a breakout that occurs against the trend may indicate the beginning of a possible trend reversal, it more likely that institutional traders are playing a smart one on retail traders and the trend will likely continue.

The GBPUSD chart below shows a downtrend, with the price breaking below a support level, which then became a resistance level.

A pullback later broke above the resistance level but failed and the downtrend continued.

false-breakout-trading

In this GBPUSD chart, the price was in an uptrend. There were false breakouts below the support levels.

breakout-trading

Out of the blue

This happens when the price suddenly breaks out of a known support or resistance level on the first attempt — a rapid price movement with apparent big momentum (tall candlesticks) surges through a resistance or support level. 

The apparent show of huge can make you think that the move would continue, and you jump in (not wanting to miss out), only to watch the price reverse almost immediately with a greater speed than it had moved — more like they were waiting for you to hop in and get trapped.

But here’s the thing : when you see such out-of-the-blue breakout, know that the price is stretched out and the move is unsustainable — the price didn’t first build up enough energy to break that level.

So, it’s just the smart money playing their game, trying to trigger stop orders and lure in market orders so that they can fill their own orders in the opposite direction.

The WTI Oil chart below shows a sudden climb above the resistance level, and it failed. 

breakout-trading-strategy

The types of breakouts to trade

Now, let’s look at situations when a breakout is likely to work out. But you should know that even in these situations, a breakout can fail and do fail on many occasions.

So trade at your discretion and always use a stop loss. Here are the types of breakouts to consider:

Breakout in the trend direction

The general market wisdom is to trade in the direction of the main trend, and the same goes for breakout trading too.

 A market in a trend continues in that direction until the trend is proven to have reversed, according to Dow’s Theory. A breakout in the trend direction is a continuation of the trend.

As you may already know, in a trending market, the price moves in waves (swings) — the stronger and longer impulse waves move in the trend direction, while the shorter and weaker corrective waves (pullbacks) move in the opposite direction.

These swings tend to reverse at support or resistance levels, depending on the trend direction, but for breakouts in the trend direction, we are only interested in the impulse swing reversal levels.

In an uptrend, impulse swings move upwards and reverse at resistance levels, so when the next upswing breaks above the previous swing high (resistance level), the move is in the trend direction and is likely to continue.

And here is why : in an uptrend, traders usually place buy stop orders above the resistance level so that they can be in a trade when the price breaks above the resistance level to continue trending up.

There are also stop loss orders of those who went short. Those huge numbers of buy stop orders plus the new buy market orders that come in when the breakout happens helps to push the price higher.

For a downtrend, the impulse swings move downwards and where they reverse is considered a support level.

If that level is broken by the next downswing, the drop will likely continue. The reason is that the huge number of sell stop orders (including the stop loss orders of previous buyers) lying below the support level will be triggered, and sellers, who were previously on the sidelines, will come in with huge sell market orders.

In the Apple chart below, the market was in an uptrend and the price broke above the resistance level. Notice the gap that occurred immediately after the breakout candlestick.
breakout-with-a-gap

The S&P 500 Index chart below shows the Covid-19-induced bear market on the H1 timeframe. Notice how the price broke below the support level.

breakout-trading

Breakout with a buildup

Another thing to consider when looking to trade a breakout is how the breakout happened.

A breakout that is likely to work would take time to build strength around the support or resistance level before the breakout happens.

This can be seen in the number of touches the price made at that level. There may also be a tight price consolidation at that level. In other words, the price will first cluster around a level it’s trying to break.

Do you know why it happens this way? The price is taking time to absorb all the opposing orders lying at that level.

If it is a resistance level there will be sell limit orders and take profit orders of previous buyers, which the bulls must absorb before they can push the price higher.

The fact that the price clusters around that level instead of making an outright downward reversal shows that the bulls mean business, and a genuine upward breakout is likely.

The USDCAD chart below shows how price bars clustered around the resistance level before breaking above it.

breakout-strategy

At a support level, there are usually buy limit orders and take profit orders of those that sold at a higher level, and the bears must absorb them all before they can move the price lower.

Since the price isn’t making an outright reversal but, instead, cluster at that level, the bearish pressure is strong and the level may give way to a sustained decline.

In the NZDUSD chart below, you can see how the price bars clustered around the support level before the price broke through the level. 

price-action-breakouts

Breakout from a range

A range is a situation where the price is oscillating between two well-established boundaries — the upper boundary is the resistance zone, while the lower boundary is the support zone.

When the price gets to the lower boundary, the bulls push it up, and when it gets to the upper boundary, the bears push it down.

Regarding the stages in the market, a range could denote an accumulation stage, where institutional traders are busy accumulating long positions before pushing the price up.

It could also occur at the end of an uptrend, during the distributive stage, when the institutional traders gradually offset their long positions with short positions, in readiness for a decline.

But more commonly, the range represents a temporary price consolidation in a trend.

It is difficult to tell whether a range is an accumulation/distribution phase or a consolidation in a trend.

Whatever is the case, it’s safe to assume that the breakout can happen in either direction, though, the trend direction may be more likely. 

A break above the upper boundary of the range will likely lead to a sustained up move, while a break below the lower boundary may lead to a sustained decline.

Another important factor to consider here is the duration of the range —the longer the range, the more explosive the breakout will be.

See the NZDUSD H3 chart below where the price ranged from July to August before dropping heavily.

price-action-cluster

Breakout of chart patterns

Chart patterns are very important to price action traders. They are identifiable price structures that occur in the price chart.

The common chart patterns include the triangles, wedges, flags, and pennants, which are considered continuation patterns. 

When the price breaks out of these patterns in the direction of the trend, it is more likely that the breakout will work because a lot of traders are already watching the patterns, eager to enter a trade on a breakout of the pattern. So, it is more like a self-fulfilling prophecy.

The reversal chart patterns, such as the head and shoulder or the inverse and the double top or bottom, are also traded with breakouts — the breakout of the neckline.

These sorts of breakouts have a higher chance of working because of what they represent — the accumulation/distribution stage.

In this USDJPY chart, the price is trending upward. Notice the triangle and how the breakout happened in the upward direction.

breakout-of-triangle

The USDJPY chart below, you can see a double bottom pattern serving as an accumulation stage where institutional trader amassed long positions before pushing the price up.

breakout-trading-strategy

Breakout of an inside bar on a higher timeframe

An inside bar pattern — what the Japanese call the harami pattern — is a 2-candlestick pattern in which the range of the second candlestick lies entirely within the range of the first candlestick.

Traders usually place stop orders above the high or below the low of the second candlestick (the inside bar) or place a market order when another candlestick closes above or below the inside bar.

Thus, the high and low of the inside bar are important price levels to take note of when you step down to a lower timeframe.

For example, if you notice an inside bar on the D1 timeframe, you can mark the high and low levels and step down to H4 or H1 timeframe and trade the breakout.

Similarly, if you see an inside bar in a W1 timeframe, you can step down to the D1 or H4 timeframe and trade the breakout of the high or the low. 

This type of breakout is likely to work because many traders are seeing the pattern and trading it in their own different ways — some trade it as a candlestick pattern with stop or market orders above or below the high/low, while others trade the level on a lower timeframe as breakouts. But like every other pattern, the breakout can still fail.

The EURUSD chart below shows an inside bar on the D1 timeframe. Notice that it formed around a support level, giving it a bullish significance. So a bullish breakout above the bar’s high is expected.

breakout-of-trendlines

This is the chart in an H4 timeframe. Trading the breakout above the inside bar’s high would have yielded a great result. 

breakout-of-inside-bar

Hikkake pattern breakout 

When an inside bar (harami) breakout fails, a hikkake pattern may be in the cards. You should look out for it because it tends to work on many occasions.

A hikkake pattern is a multi-candlestick pattern that involves a false breakout of an inside bar pattern and a price close above or below the opposite end of the inside bar’s range (high/low).

In essence, it is a breakout at the opposite end of the candle’s range after a false breakout at the other end.

That is, if there was a false breakout below the inside bar’s low, and the price turns upwards and closes above the high of the inside bar, a bullish hikkake pattern is formed.

On the other hand, a false breakout pattern at the high of the inside bar will lead to a bearish hikkake pattern if the price closes below the low of the inside bar.

Here is why this type of breakout works: the smart money (institutional traders) intentionally caused the false breakout to lure retail traders so that they can get enough orders to fill their own order in the opposite direction. Once they get enough orders, they push the price in their intended direction. 

In other words, if they are looking to go long, they cause a false downward breakout at the inside bar’s low to lure sellers into the market so that they can get enough sell orders to fill their own buy orders.

If they are looking to go short, they cause a false breakout above the inside bar’s high in order to get enough buy orders to fill their short positions.

So, the hikkake pattern is like a digital signature left by the smart money. The pattern is quite rare and difficult to spot because the smart money is smart enough to hide the footprints they leave in the market, but if you spot a good one, the success rate is high.

The EURUSD chart below shows a bullish hikkake pattern breakout. You can take profit at the resistance level or ride the trend.

Hikake-breakout-trading-strategies

In the EURUSD chart below, you can see that bearish Hikkake pattern. Notice that the support level is a perfect place for a profit target. Can you see the bullish hikkake that formed at the profit target? 

False-breakout-trading-strategies

Conditions that favor a breakout

Certain market conditions favor breakouts more than others. Trading a breakout strategy when there are such conditions in the market increases the chances of the trade working as expected.

But that does not mean that any breakout that occurs when these conditions are present in the market will work fine.

The breakout must be of the tradable type first before looking for any of these conditions. Having said that, these are the conditions to consider when trading a breakout strategy, especially if you are a day trader :

Market open : A breakout trade is more likely to work if it occurs around a market open.

In the forex market, the major market opens to consider are the Frankfurt/London open and the New York open.

For stocks, the only open that matters is that of the stock exchange where the stock is listed.

The period around the market open is always associated with high volatility, so the price can have enough momentum to progress rapidly after the breakout.

Following high-impact news or political events : Political events, finance ministers meetings, central banks’ meetings and reports, economic data releases, and other high-impact events often come with increased volatility in the market.

A lot of people are expecting the news and orders begin to flood the market once the news is released. If a legitimate breakout occurs in such a condition, the chances that it will work seem higher.

Less than average daily range : A breakout that occurs when the price movement for the day is far lower than the average daily range is more likely to work because the price still has much space for movement in that direction.

Here is the thing : If the average daily price range is 100 pips and the price had only moved 30 pips when the breakout occurred, there is still about 70 pips space for the price to move in that direction on that day.

Compare it to a situation whereby the price has moved 80 pips for the day before a breakout happens — the chance that the price will continue moving in that direction is lower.

Different ways to trade a breakout

There are different ways to enter a breakout trade; it all depends on the trader’s style and emotional control.

While some traders like to ride the initial momentum that follows a breakout and can’t stand the fear of missing that move, others prefer to wait at the train station, as they can’t afford to see the price pull back against them. Thus, these are the two ways to enter a trade after a breakout:

Breakout candlestick close

With this method, you enter your trade immediately the breakout candlestick has closed.

You can either enter with a market order as the next candlestick is opening or you place a stop order above or below the breakout candlestick’s high or low — if it is an upward breakout, you place a buy stop order above the high, but if it is a downward breakout, you place it below the low.

Stop loss : Place it below the preceding swing low if you are going long after an upward breakout.

In the case of a downward breakout where you are going short, place your stop above the preceding swing high. 

Profit target : Your profit target will depend on the type of breakout you are trading. If you are trading a chart pattern, you can easily estimate your profit target with the height of the pattern.

For a trend-following strategy, you can trail your profit. You can also place your profit target at the next resistance or support level or use a Fibonacci expansion level. 

breakout-trading-tactics

The retest of the breakout level

Some traders prefer to wait for the price to pull back and retest the breakout level before they can look for a trade setup.

If you see yourself in this category, you need to have a clear criterion for your trade trigger — it can be a reversal candlestick pattern, such as the pin bar, engulfing bar, or inside bar, or an indicator signal like an oscillator divergence.

One problem with this breakout strategy is that not all breakouts come back to retest the breakout level, so you can miss some breakouts.

head-and-shoulder-breakouts

Final words

Breakout trading strategy works if you know how to trade it and when to trade it. We have discussed the types of breakouts to avoid, the types to trade, the conditions that favor breakouts for day traders, and the various ways to enter a breakout trade. Study them to see how you can adapt them to suit your trading style.

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