When you trade Forex, you need to stack the odds in your favor. That just not possible or even practical. If you are trading with a good risk to reward ratio then you can be right on less than half your trades and still make very healthy returns. You have to know how to spot a nice opportunity, and be ready to execute your trade plan according. Some of these high probability trading opportunities are provided when trading breakouts in Forex. So in this lesson, I will discuss some of the advantages of trading Forex breakouts and go over a few breakout trading techniques.
We have a breakout when the price of a Forex pair overpowers and eventually breaks out of a specific psychological level. When you look at the price behavior on a chart, you will notice that the prices typically tend to move within and conform to specific levels. When you see the price hitting a level and quickly reverse, we consider this as an important clue about the strength of the level.
And so when price comes back to retest that level, we have to watch price action closely and anticipate a potential breakout or rejection trade setup. Sometimes, you might see the price hitting the same level a few times. This means that the particular level may be stronger than usual. However the price will eventually break thru any contained levels at some point. This is when we have a breakout trading setup. Breakout trading setups in Forex can provide nice trading opportunities.
The reason for this is that breakouts often lead to new price moves and trends. In this manner, traders attempt to enter the market right when a breakout occurs in order to get in early on a potential emerging trend.
In addition, many of the more reliable breakouts tend to occur on high momentum, and price action traders attempt to maximize their profit from the rapid price moves.
Breakout trading is a simple and popular trading technique used by many Forex traders for good reason. Breakouts occur on psychological price levels. One of the reasons, breakouts can move prices quickly, is that the levels around the potential breakout are being watched by many market participants and when one side is able to push thru, the other side has to quickly cover their losing positions, thereby creating sharp price movement after breakouts.
There are many different types of breakouts, including horizontal price breakouts, trend line breakouts, Fib level breakouts, Moving Average breakouts , and more. It is our job as traders, to find high probability breakout opportunities and execute the trade. But when trading breakouts in Forex, it is not always so clean cut. Typically support resistance lines drawn at potential breakout points should be considered as zones rather than fixed lines. A breakout system requires the use of trader discretion to minimize false signals and fakeouts.
However, the bottoms of the price action cannot be connected with a single straight line. It actually means that the trend should not be considered as being contained by a single thin line.
Rather, on the contrary, the trend should be perceived as a zone. If the price does pierce thru and interrupt the upward sloping trend line, does this mean that the trend is over? Sure we have to be cautious of a potential reversal, but keep in mind that price can and does pierce a trendline at times, without reversing price. The price will fluctuates dynamically and small breaches through levels are always possible.
And this is in force not only for trendlines. This rule applies also to any other level. Therefore, we need to learn how to identify the real breakouts filter the fakeouts as much as possible. When you realize that the price is conforming to the same level over and over again, you identify that a psychological area is present. Of course, if one of the candles on this level has a wick which goes far beyond the logical scope of the level, we disregard it as part of our psychological area.
Let me show you an example of a breakout through a support area: As you see, after an uptrend, the price switches directions and starts a downward move. When a certain level is reached, the price starts moving sideways, creating a consolidation. Meanwhile, there are a couple of bottoms created.
We use the blue rectangle to frame the area around the lower wicks of the candles, which creates our support area. On the above chart, when the price closes a candle below our support area, we identify this as a bearish breakout.
After that, the price resumes its downtrend. Notice that the price has formed a Descending Triangle. Descending Triangles are technical chart patterns that show price contraction, and this formation, like other contracting patterns, will eventually lead to a breakout and create a new price movement.
The direction of the breakout is typically unknown. This means that the breakout from the pattern could send the price in either direction. For this reason, we should carefully watch both the support and resistance levels for potential clues. Whenever we identify the likely breakout direction, we should react with a position in that respective direction. Notice in this example, that I have framed with rectangles the upper and the lower levels of the triangle.
This way I know the exact areas which the support and the resistance of the triangle are likely to cover. Notice that on the lower side of the triangle there is a candle wick which goes deep into the support area. If we had just a single line indicating our support, the wick might have lured us into thinking there was a bearish breakout. In the red circle you see the exact location of the eventual breakout, which was to the upside. Notice the strong momentum on the breakout illustrated by multiple green marubozu candles.
After the price breaks through the upper level of the triangle, it then retraces back in order to test the already broken resistance which is now considered a support area.
This type of breakout pullback scenario is a very important confirmation signal in breakout trading, which we will discuss later in the article as well. For me it is a general rule that a candle wick beyond a psychological area is not a breakout. I consider a real breakout to occur only in situations when the price of the pair closes the candle beyond the level.
This way we get a more reliable breakout signal, one which can be used to trigger a position in the respective direction. Have a look at the image below: Again, we have a descending triangle with an upper resistance area and a lower support area.
I have marked these with the blue rectangles. Notice the way the rectangles contain the bottoms of the price. The lower rectangle is located according to the first and the second bottom of the triangle. The upper rectangle contains all the tops of the price, except one candle which is pin bar style rejection candle. This is our first fake breakout. We have only a candlewick going above the resistance area. However the candle does not close with its full body above the resistance area.
For this reason we disregard this breakout signal and we would classify it as a false breakout. We get a second fake breakout afterwards.
The last bottom of the price goes below the support area with its candle wick. The candle is also a Pin Bar formation , also called a hammer pattern, and bounces strongly off the support zone. Again, since we have no candle closing below the support area, we would disregard this as a breakout signal. The Pin Bar subsequently pushes prices higher and five periods later we have a candle closing above the resistance area.
This is our valid breakout signal. Notice that the breakout candle is a strong Marabozu candle, which further confirms that this would be a reliable breakout signal. Actually, it is not enough only to see the price breaking through a certain level in order to take a position in the respective direction. Though you can certainly initiate a trade after the initial candle close beyond the breakout point, there are better entry techniques in my opinion.
They do require more patience on the part of the trader, and do not always materialize. But keep in mind, we are looking to trade the highest probability breakout trades, and not just every setup that comes around. Therefore, I have prepared 4 steps for you, which will confirm a breakout and we will set certain rules for triggering a breakout trading position. The following example illustrates a bullish breakout: A breakout appears as in the examples above.
We observe price increasing and eventually goes through a psychological resistance. The price closes a candle above the resistance and we identify the breakout.
The price creates a top after the breakout. In this example, the increase continues for two more periods, and then starts to move downward. This creates the top we need. Typically the top we are looking for will be a fractal formation, meaning that the highest high will have two bars to the left of it with lower highs and 2 bars to the right of with lower highs.
The reverse would apply for a bottom. The price retraces back to the already broken resistance and tests it as a support. The decrease continues and the price tests the already broken resistance as a support. When the price touches the broken resistance, it bounces upwards, implying that this is now a strong support area.
The top after the breakout gets broken. After we see a candle closing above the top, which was settled after the breakout, we have a strong confirmation that the price might really continue in this direction. Such situations are extremely useful to trade. You could apply this 4 step breakout signal confirmation in order to trade range consolidations.More...