Breakouts are considered to be the perfect market situation for entering a trade. This led to the popularity of trading strategies focused on making profits from the volatility that follows a price breakout. Breakout strategies can work in almost all financial markets, including the forex market. If you are able to spot a breakout in time, that can be an ideal trade setup to dive into for some easy gains from currency price fluctuations. But, it’s important to manage risks even if you find an ideal trade setup, and that can be done with the help of different trading tools. In this article, you will get some relevant information about forex breakouts and how to trade forex using the breakout strategy in the best possible manner.
Basics of Breakout Trading
Before moving on to the technicalities of breakout trading, you need to understand some basic essential terms to get started. Those who are familiar with price charts must be aware of the support and resistance levels. Support and Resistance levels have a key role in breakout trading, as identifying a breakout or potential breakout is impossible without determining the support and resistance levels from the chart. The concept of support and resistance is based on the supply and demand for a trading instrument. The support stands for strong demand, and resistance represents an increase in supply.
Support is the level at which prices of an asset stop dropping; it is the point at which an upward movement can be spotted with an increase in buying activity for the particular trading instrument or currency pair in context to forex trading. On the other hand, resistance stops the prices from rising any further as the sellers overpower the buyers at that level, which increases supply, triggering a fall in prices. The support and resistance levels indicate a crucial point when the demand and supply forces come together. The study of support and resistance levels is critical for technical analysis.
Now, talking about breakouts, they can happen with both support and resistance levels. A breakout can be bullish and bearish, depending on how it happens. When the price of an asset breakout above the resistance level, it is a bullish phenomenon, whereas the price breaking below the support level is seen as bearish. In the case of other asset classes, breakout trading will consider the trading volume. Still, when it comes to forex trading, the strategies will also consider the market volatility at the moment of trading.
The volatility tells us about the extent to which the prices can move within a specified time period, and in forex, price movements are expressed in the number of pips. Hence, pip calculations are also relevant for implementing forex breakout strategies. You can rely on basic yet automated tools like a pip calculator to understand and obtain the right pip value, which differs for each currency pair. The monetary value will depend on the base currency of your trading account.
Breakout Trading in Simple Terms
As I stated earlier, breakouts can happen in both directions. Identifying this direction is crucial to determine the type of position you should take to profit from the breakout. Two types of breakouts can happen in the currency market. The first one is a typical reversal breakout, followed by a trend going on for a longer duration. Finally, it ends with a breakout happening prior to a much-awaited reversal, and the price tends to move in the opposite direction later on. If there is a reversal breakout during a bullish trend, the price will start dropping, and if the reversal breakout happens during a bearish trend, you can look forward to the uptrend that will follow.
The 2nd one is the continuation breakout, which tends to happen during a consolidation where the trend pauses and takes a break. But here, the market continues to move in the same direction without any reversal. The third type of breakout is the trickiest one: the false breakout. In this case, the breakout was only a false alarm as the trend is neither reversed nor continued, but the price will get stuck in a range following a short spike. It is also referred to as fakeout, and mistaking it as a breakout can be troublesome for a trader. In short, understanding the type of breakout that happens is essential to determine the direction in which the prices will move after that.
Best Ways to Identify Breakout Trading Opportunities
There are 3 ways to identify a price breakout resulting in a trading opportunity. I suggest confirming a breakout using all 3 methods to avoid placing trades in a false breakout.
- Looking at Support And Resistance Levels
The first method is to identify the support and resistance levels on a price chart. For this, you need to analyse the candlestick charts, the standard chart type used by forex traders due to their detailing and comprehensiveness. You can add technical analysis tools like Pivot points and Bollinger bands to your charts to better understand the market situation.
- Considering Volume and Volatility
As I stated before, volume and volatility must be considered before trading a forex breakout. A breakout at peak market hours with high trading volume would be an ideal opportunity to trade since entry and exit will be easier. Forex breakouts will also be affected by the market volatility to some extent, and you need to consider that while finding opportunities for breakout trading.
- Using Technical Indicators
The RSI indicator that identifies the overbought and oversold levels for a currency pair can be particularly useful for breakout trading as it is connected to the demand and supply conditions. You can also add the popular MACD indicator to your charts, as it is a powerful tool to confirm breakouts.
How to Get Started With Breakout Trading?
Once you have understood the theory behind breakout trading, apply this to your trades after some practice. The first step is identifying and confirming a breakout with the above-mentioned methods. Then, you can start planning the trade based on your strategy.
- Entry And Exit Points- Your trade’s entry and exit points determine your trading results in the end. You need to do some calculations to assess the trade’s profit potential, adjust the stop loss, and take profit levels based on that. You can make the calculation part easier by using a profit calculator, a simple yet effective tool for planning and managing your trades.
- Risk Management – You need to prioritise risk management while following any strategy. When it comes to breakout trading, you need to consider your risk tolerance and only trade when the breakout has enough profit potential to confirm your risk/reward ratio. Optimal position sizing along with the use of trailing stop loss, are recommended to minimise potential losses in case the breakout fails to meet your expectations.
Risks and Rewards of Breakout Trading
The first risk of breakout trading is the possibility of a false breakout, so I suggest not trading every breakout you come across. You need to be patient and use all the available tools to confirm the breakout before taking a position. The volatile nature of the forex market adds up to the risk, and unpredictable price movements can make breakout trading tough for an average beginner.
Still, breakout trading is one of the most commonly used strategies in the forex market because of the high profit potential and countless trading opportunities you get by simply waiting for a breakout. A breakout is still the perfect entry point for a trader who couldn’t place a trade during the previous trend. Forex breakouts are also easier to spot and provide enough trading opportunities across different time frames, making them suitable for short-term and long-term strategies.
Devising A Breakout Trading Plan
- Set Clear Trading Goals – Firstly, you need to set clear trading goals as that allows you to plan your trades in a practical manner. Make sure to state your profit targets, timeframe for trading and how much risk you are willing to take for the trades.
- Selecting Suitable Currency Pairs – Make sure the currency pairs you choose are suitable for breakout trading with enough liquidity and volatility. I suggest you stick with major pairs and minor pairs.
- Backtesting – The last step is Backtesting, which is essential to ensure your strategy’s success before risking real money.
Now, you have learned all the basics about breakout trading in the forex market, and I hope you can develop a solid trading plan using this information. Breakout trading strategies can work well for patient traders who follow a disciplined approach.