As a forex trader, one phenomenon that you will come in contact with almost every week is the breakout. The breakout trade is the basis of many forex trades that have made some good money for those who know how to use it, but it has also been an albatross for those who do not know how to recognize it or who neglect to make use of it in their trading decisions.
Not all orders placed in forex will be market orders. Sometimes a trader will need the price action to move into favourable territory before execution. The breakout is therefore a good tool which can help make such a determination.
This brings us to the question: what constitutes a breakout in forex? A breakout occurs when the price of the asset (which has otherwise been contained within a specified range by key levels of support/resistance) receives a momentum that causes it to push through these key levels to move either higher or lower than the initial range in which it was contained. The breakout is usually accompanied by heavier trade volume.
The critical factors in deciding how to trade a breakout are the key levels of support and resistance. Support and resistance in forex can be determined in the following ways:
- Using the daily pivot points (R1,R2,R3, central pivot, S1, S2 and S3) .
- Using previous price action which detailes areas where price did not go above (support) and areas where price did not go below (support).
- Psychological support/resistance levels, which are seen when the price forms round numbers (e.g. 1.7000, 1.6800, etc).
Three events could possibly occur when the price action reaches these key levels of support or resistance:
- The price action may bounce off the key levels after striking them repeatedly without breaching them. These are simply “tests of support” or “tests of resistance”.
- The price may breach these key levels, but do not close above the resistance or below the support levels when the candlestick closes. Some call this a fake breakout or “the fakeout”.
- The price may close above the resistance, or close below the support. This is a true breakout.
Many traders cannot distinguish between a fake breakout/fakeout and a true breakout, which is why many traders end up mistaking the second scenario for a breakout and end up being faked out. The currency pair being kept in view MUST actually close above the resistance or closes below the support to constitute a breakout.
TRADING THE BREAKOUT
When price breaks through a level of support, the broken support turns into a new resistance. In the same vein, a break of resistance converts that level into a new support. These two scenarios are the basis of the breakout trade.
Here are the steps to trading a breakout in forex.
The trader must distinguish between a true breakout and a fakeout. The only way to do this is to allow the candlestick in view to close, and then note its closing price in relation to the resistance or support level. For a breakout, the closing price must be above the resistance or below the support. Anything else is not a true break and should not be traded.
The reason why traders get faked out is because they take their decisions based on the price action merely breaching the key levels without closing above the resistance or below the support. It is very important that the trader has the patience to allow the candle to close.
From my personal experience, I have found that 2/3rds of the time, the price action tries to go back to where it came from after a breakout. It then gets rejected at the level just broken and then resumes the movement in the breakout direction. It is therefore better to allow the candlestick breakout to occur, then wait for the next candle to open and try to force the asset back to where it was coming from (in the direction opposite the breakout). This causes the candle to halt at the old support now turned resistance, or the old resistance now turned the new support.
Once this happens, you can use a MARKET BUY order to trade the resistance breakout if you are close to your computer when this is happening. If you will not be close to your computer, use a BUY LIMIT order with the entry price set at the level of the broken resistance.
If trading a downside break of support, you either wait for the next candle to force its way back up to the support-now-turned-resistance and sell the asset at market price, or use a SELL LIMIT at that key level if you will not be close to your PC.
This setup has a good degree of accuracy. You can see the charts below for examples:
Example 1: Upside breakout
Here, we see the price of the asset resisted by the resistance line (the black circled points), and we also see two fakeout candles which breached the resistance but closed below it. To the right, we now see a true breakout candle, and the next candle which retreated to the old resistance/new support, before continuing the move higher.
Example 2: Downside breakout
Here we see prices bouncing on the support, with a number of fakeouts. We eventually had a true breakout, and the candles tried to drag prices upwards but the support now turned resistance was too strong. It is at this point that the trader should either place a SELL at market price, or if the trader is unsure of being at the computer to place the trade as it occurs, a SELL LIMIT order using the new resistance as entry price can be used.