This article aims to explain the breakout as it occurs in the forex market and how traders can take advantage of this occurrence. When you consider the fact that breakouts occur on forex charts very frequently, it puts a responsibility on the trader to get acquainted with breakouts, learn how to recognize them and how to position themselves to take advantage of them.
What is a Forex Breakout ?
A breakout in forex occurs when the price action of a currency pair performs a strong movement as to extend beyond a pre-established range of prices. In other words, a forex breakout is seen immediately after a period where prices have been in consolidation or have been range-bound. This will be illustrated in some of the setups later on in this article.
What Triggers the Breakout?
To better understand the factors that trigger a breakout, it is pertinent to understand when they tend to occur. Breakouts tend to occur in the following scenarios:
- Immediately following the release of a major economic news item.
- After a period where price has remained contained within specific boundaries e.g. such as when price is contained within the borders of chart patterns, pivot points or channels.
There are two sides to a trade: the buy (long) and the sell (short) sides. Breakouts are triggered by a massive influx of traders into the market as they take positions on one side of the trade in excess of the other side after a period of sitting on the sidelines awaiting major market news to give them trade direction. The price of the currency therefore follows the law of demand and supply. The more demand/less supply there is for one of the currencies in the pair, the more likely it is that the breakout will occur in the direction which gives that currency more value.
Let us use the EURUSD as a focus currency to explain this. If the EURUSD has been range-bound for some time and a news release comes out to impart potential value to the US Dollar, we will likely see more trade orders selling the EURUSD and causing a downside breakout.
Principles of Breakout Trading
OK, so now we know the theory behind a breakout. But the question is: how can you as a forex trader, recognize a breakout when it occurs? Timing is important in trading the breakout so you’ve got to be able to spot one when it happens and act on it before the ship sails.
A breakout occurs in the following circumstances:
- Setup for a long trade: there is a bullish candle which rises up to close above a resistance
- Setup for a short trade: there is a bearish candle which goes down to close below a support
Please take note of the terminology. The candles in question must be allowed to close, and they have to close on the other side of the support or resistance lines. Merely going to the other side without closing is not enough, as the position of the closing price relative to the key level of support or resistance has to be used in making the breakout trade decision. There are numerous examples of candles which breach these key levels, only for some late reversal action to send them back to where they came from. These are “fakeouts” and will only produce losses.
Recognizing the breakout is one part of the equation. Knowing how to trade it is another. Here is how to trade the breakout.
- Breakouts can be traded long or short. You must allow the breakout to occur in either direction as already described.
- More than two-thirds of the time, the price will attempt to cross back to where it came from. However, the broken key level of support or resistance will resist this return. Therefore, the broken levels will serve as the springboard for the new trade.
- The Limit orders are the best to use in trading breakouts. So to trade an upside breakout, allow price action to start retracing to the broken resistance line (now turned support), and set a BUY LIMIT entry using the price at this line as the entry price. For a downside breakout, allow price to start retracing upwards to the broken support (now turned resistance), and set a SELL LIMIT entry using the price at this line as the entry price.
Classic Examples of Breakout Situations in Forex
To round off this article on the breakout, we will illustrate the commonest breakout scenarios you will encounter in the forex market. You will most likely encounter breakout strategies in the following situations:
a) During a major news release which comes immediately after a period of market consolidation. Trend lines drawn across the price highs and lows will delineate the range of prices within the consolidation period so that spotting the breakout will not be a problem.
b) When price bursts out of chart patterns that enclose price action for a while. Examples of such patterns are wedges, triangles and channels.
Breakout from a wedge pattern
Breakout from a channel
c) Breakouts can also be traded out of the pivot points that are plotted on the hourly charts. Please note that only the 1 hour charts can be used to trade the pivot point breakouts.
Breakouts from pivot points
For the pivot point breakout setups, you need an automated pivot point calculator to plot the points afresh every new trading day. This not only takes the stress of daily manual calculation away, but also provides a visually appealing and accurate plot which the trader can easily trade off from as soon as the signal appears.
When setting the stop loss and profit targets for breakout trades, these principles hold sway:
- The Stop Loss (SL) is set below the broken resistance or above the broken support. This enables the trader to use little risk and seek for more reward.
- The next logical key levels in the line of the breakout movement should be used to set the Take Profit targets.
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