Breakout trading is a common trading technique in all financial markets and breakout traders make a significant portion of all forex traders.
This trading technique has existed for a long period of time and it is taught in many books as well as online.
However, you will find many myths online about this trading strategy, and some of these are not true.
This trading strategy can be very profitable under certain market conditions.
This means that not all breakout traders lose money.
However, a number of traders have not been successful trading breakouts.
So, before jumping and beginning to use this strategy to run your trades, it will be good for you to test it and know whether it will work for you.
You should also learn the forex breakout rules that will help you stay away from disasters.
This will prevent you from taking unnecessary risks.
You should analyze the risk before you enter the market so as to know whether the trade is viable or not.
In this article, I will help you know some of the strategies that you can use to make profit when trading breakouts.
What is Breakout Trading?
The goal of breakout traders is to trade in the direction of a movement once the movement begins.
The basic idea behind this trading technique is that once the market breaks a level that is deemed significant by the trader, the market has higher chances of continuing in the direction in which the breakout has occurred.
Breakout traders monitor many different types of levels in the market where they suspect that a breakout will occur.
Such traders normally enter into breakout trades using pending orders placed at these levels before the occurrence of the breakout.
Examples of such levels include the support and resistance lines, Fibonacci levels, etc.
However, the support and resistance levels form the popular way of identifying breakouts among forex traders.
Consider the following chart…
The above chart shows the occurrence of a breakout through the resistance line.
The resistance line is the black line running horizontally across the chart.
Most breakout traders would have identified the resistance line as a place where a breakout is most likely to occur.
They would have marked the level on their charts and placed pending orders.
The candle pointed to by a black candle marked as Bullish Breakout is very important to the traders.
This candle marks the exact place where the breakout occurs.
Prior to this, the price had made numerous attempts to break through this line upwards but it kept on failing.
This means that this line is acting like a resistance level.
Since the breakout occurred through the resistance line upwards, it is a bullish breakout.
When this candle closed above the resistance line, many traders would have entered long positions either using pending orders that they had placed or through market orders after they had seen the occurrence of the breakout.
The chart shows that after the occurrence of the breakout, the market continued to move higher.
This means that the traders who had taken long positions after the breakout were right and they will make profit from the upwards trend.
The breakout traders could also have watched for swing highs and swing lows in the market.
Consider the following chart…
The above chart shows the swing highs and swing lows that breakout traders should have watched for in the market.
The levels marked with small black horizontal lines show the areas that breakout traders should have placed their trades in anticipation for breakouts.
A closer look at the chart reveals that the market begins to move in the opposite direction once the price hits these levels.
If the price was moving downwards and it hits the level, it bounces and begins to move upwards.
If the price was moving upwards and it hits one of these levels, it bounces and begins to move downwards.
This has created swings within the price chart.
Why do Traders Lose Money in Breakout Trading?
In this section, I will be showing you how breakout traders lose money in the market.
Consider the following chart…
The above chart shows the occurrence of a bearish breakout in the market.
The breakout is bearish because it breaks out through the support line downwards.
The support line is the black line running horizontally across the chart.
A breakout occurred when a bearish candle closed below this line.
This is the red candle pointed to by a black arrow marked as Bearish Breakout.
After the breakout, the price moved downwards for some time and then made a pullback.
This led to a short bullish move in the market.
The price came back to retest the former support line which is now acting as a resistance line.
What you must know is that the role of a support or resistance line changes after a breakout occurs through it.
If you had a resistance line and the price breaks out through it upwards, it will begin to play the role of a support line.
If you had a support line and the price breaks out through it downwards, it will begin to play the role of a resistance line.
In the above case, the line which was acting like a support line has changed and is now acting like a resistance line.
The price had to come back to retest it to know whether it has developed into a strong resistance line.
After retesting the former support line, the price found that the line has changed to become a very strong resistance line.
The price bounced quickly and begun to make a bearish move.
This acts as a confirmation that the bearish breakout was valid.
When the price retests the level, it gives an opportunity to traders who did not enter into the market after the first breakout to enter into trades.
It could also be a trap for breakout traders to close their trades and lose money.
The bank traders want to place their own trades in the market, hence, they want breakout traders to close their trades.
Consider the following chart…
The above chart shows the occurrence of a bullish breakout in the market.
The breakout occurs at the position pointed to by a black arrow marked as Bullish Breakout.
In the above chart, the bank traders want to place buy trades, hence, they need sell orders to come into the market to accomplish this.
A high number of these sell orders will come from breakout traders who went long.
Due to this, they closed their trades at a loss which makes them use sell orders.
After a slight movement to the upside, the market will stop moving since the bank traders will be taking profits.
When the pending orders for the traders are hit, there will be a high number of buy orders getting into the market, and this is exactly what the bank traders want to see.
By the time the market manages to break the highs, the bank traders will have already made significant profits from their trades and they will need to take some profits from the market.
The only way for them to achieve this is by having fresh buy orders get into the market.
But the question is…
Where do the buy orders come from?
They come from breakout traders.
So, as the breakout traders place buy orders to enter into trades, bank traders get an opportunity to take out their profits.
The bank traders take out their profits at the point where the price enters a consolidation period and begins to make a reversal to the downside.
After all the buy orders from breakout traders have been consumed by sell orders from bank traders who are taking off profits from their traders, the market starts to move lower.
This downwards movement will make breakout traders to begin closing their trades since their profits will be decreasing and the fear of losing money starts to take over.
Some reversal traders will also begin to believe that the market will continue going down in the same direction as the trend.
These traders will then begin to enter into short or sell trades.
So, you are now aware that once the market begins to move down after a breakout, there are two sets of traders who begin to sell…
The first group is made up of breakout traders who are scared of not making any money.
The second group is made up of reversal traders who think that the downwards move will continue for some time.
With these two types of traders selling, it means that the market will receive many sell orders.
But, what do you think will the bank traders do after receiving such a high number of sell orders?
They will buy!
The bank traders will see an opportunity to make more money, and it will become easy for them to place buy trades because of the high number of sell orders in the market.
They will also know where their profits will come from, that is, reversal traders.
Once the market stops moving down but instead begins to move up, the reversal traders will be forced to close their trades.
Their small profits will begin to disappear and they will close their trades out of fear.
The reversal traders will also hand over their money over to the bank traders who were buying at the time when the market was moving lower.
Note that the above example is not a one-off case.
This process of losing money when trading breakouts happens again and again in the market, and it is virtually the same in all places where breakouts happen in the market.
Another way through which breakout traders lose money is when false breakouts occur in the market.
False breakouts are very common in the forex market and most bank traders use them as a way of sucking unsuspecting breakout traders into entering incorrect trades.
False breakouts normally happen when the banks have not been able to place their whole trade into the market and they need more buy or sell orders in order to complete the position.
They will use their money to purposely make the market break high or low which they know that breakout traders love watching.
They also know that majority of such traders will have pending orders at the level waiting for a breakout or they are ready and willing to place a market order into the market immediately they see a breakout happening at that level.
Consider the following chart
The above chart shows the occurrence of false breakouts as well as a real breakout in the market.
The market recorded two false breakouts and one real breakout.
At the point marked as 1, we have a support line in place.
The price hits this level and tries to breakout through it downwards.
During this time, breakout traders will be anticipating for a break lower.
Since the bearish/red candle managed to close below the support line, many breakout traders will see this as a bearish breakout, and they will immediately jump into short positions.
This will be as a result of their pending sell orders and the fact that the support line has been hit, while others will enter the market using market orders.
Now that the support line is broken, many traders will believe that the market will continue moving lower, but this did not happen.
Instead, a bullish candle is formed that manages to engulf the previous bearish candle that created a breakout in the market.
This bullish candle formed after the breakout had occurred.
The bullish candle was formed as a result of bank traders buying from the traders who are selling after the occurrence of the breakout.
Always remember that bank traders don’t place trades on candles in which they want the market to go.
If they want the market to go up, they won’t place trades on bullish candles, but on the opposite candle, meaning that they will buy into the bearish breakout candle.
In this case, they will buy into the bearish breakout candle.
Next, we see a bullish candle, and majority of it is formed by traders who placed sell trades after seeing a market breakout at the support level.
These traders are now losing money.
The point marked 2 shows a case where a false bullish breakout occurs in the market.
The breakout occurred at the time when the bullish candle closed above the resistance line.
Due to this, many traders will jump into long positions.
The reason is that most of them will have pending buy orders on the resistance level.
Others will use market orders to enter into the market.
Note that these traders expect that the price action will continue moving higher.
However, this did not happen.
A reversal occurred in the market, and the bullish breakout candle was followed by a bearish candle that completely engulfs it.
This was followed by a strong bearish move in the market.
All the traders who had taken long positions are now caught on the wrong side of the market.
Let’s now talk about the point marked as 3.
This point is a typical example of how bank traders place even more trades into the market.
The point shows the market breaking out through the support level in a bearish direction.
The breakout trading followers will immediately enter sell trades while expecting that the market will continue moving lower.
This breakout was followed by a strong bearish move, meaning that traders who had taken short positions will make profit.
So, the bearish breakout was real.
That is how false breakouts are different from real breakouts.
False breakouts are one of the reasons as to why breakout traders lose money in forex.
Forex Breakout Trading Rules
In breakout trading, different approaches should be used for liquid and non-liquid markets.
Breakout traders can easily make money on forex because it is liquid.
Here are the rules that breakout traders should follow when trading forex…
#1: Don’t buy on breakout, don’t sell on breakdown
When dealing with a liquid market like forex, buying at the breakout is very risk.
This is also the case with selling at breakdown.
A low price means a high risk per sell trade.
A high price means a high risk per buy trade.
A profitable forex breakout trading strategy means not trading breakouts and not trading breakdowns.
#2: Price Change and Clear Price Action
You must look for what is moving.
This means that when doing forex breakout trading, you should look for a price change.
It will be good for you to look for best gainers and best losers.
You can look for a daily price change of 0.5% in gain or loss.
It is after getting a clear and clean price action that you will know where to focus.
Look for a possible Breaking for a Trend, a Trend Rotation, or Continuation Patterns.
If you look for the ones with a clear price action, you will have removed the ones that carry a high risk.
This will reduce your chances of losing money as a breakout trader and increase your chances of becoming a successful forex trader.
#3: Determine the Cause of Volatility looking for Particular Catalysts
It will be good for you to look at catalysts and select the right ones that cause spikes.
In non-liquid markets, traders first look for what is moving and then investigate it later.
After knowing what to investigate, you can look for news about the financial instrument.
A good example of a solid catalyst is the signing of a contract.
It causes the price of the financial instrument to spike up.
So, you will be aware of what is happening and know that the market is moving.
You can then look for the price action so as to open a trade.
You can time for the breakout of strong resistances, or consider buying in the dip on a support.
However, forex breakout trading rules tend to be a bit different.
It has a Specific Events Calendar for collecting all the news.
The Events Calendar shows a scheduling with a clear indication of volatility.
This way, you will remain aware of catalysts in advance and know their short-term impacts in the market.
So, once a report becomes public, short-term traders will ride the volatility that is induced.
The volatility may become a support resistance breakout indicator.
If the catalyst is not solid or if there are no catalysts, the risk will become so high.
#4: Where the breakout begins
The momentum is a good way of saving breakout traders from losing money.
Instead of buying on a breakout or selling on a breakdown, you can look for momentum.
That is, just look for where the momentum begins.
Consider buying at the origin of a bullish momentum and you will trade with an acceptable risk.
With this kind of thinking, trading will become easy because the risk per trade is low.
You will then have high chances of making high profits as a breakout trader.
#5: Price consolidation and choppy market
You can also consider a price that moves in a range.
A choppy chart is a signal of uncertainty between demand and supply in the market.
This has the impact of increasing risks because breakouts and breakdowns can fail many times.
So, you should wait for a spike from the uncertainty before you can think about how to trade.
Breakout trading is a profitable trading strategy if done correctly.
As a breakout trader, you must learn how to identify breakouts the moment they occur in the market.
This means knowing the positions where breakouts are most likely to occur, for example, at support and resistance levels.
You also need to learn to distinguish real from fake breakouts and how to determine the direction in which to trade breakouts.