Breakout Trading: Profiting From Forex Price Surges

Breakout Trading: Profiting From Forex Price Surges – If you’ve ever been involved in a trade where price breaks out of a long-standing resistance or support level, you must have seen how quickly the price moves and how easy it is to make money.

Trading breakouts can actually be very exciting if you are in the right direction – riding the wave like an ocean wave.

Breakout Trading: Profiting From Forex Price Surges

But if you’re on the wrong side, trading breakouts can be a real pain. And you may have experienced this by entering a trade when it breaks through support or resistance, only to watch price make a complete reversal a few periods later and knock you out of the game.

Real Life Case Studies For Successful Breakout Trading In Forex

Although it goes against the basic dogma of the market – buy low, sell high – the concept of breakout trading is not something new to traders, as many have been using it for many years. A good example is the famous turtle traders who were trained by Bill Eckhardt and Richard Dennis.

Forex traders use many breakout strategies, and in this post we will show you how successful traders trade breakouts. But what exactly does breakout trading mean?

A breakout is said to occur when a price bar closes beyond an established support or resistance area, which could be a horizontal level or a trend line, depending on the market structure and patterns you may see on the chart.

As you may already know, especially if you have read our previous articles, trend lines are nothing more than rising support levels and falling resistance levels.

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Thus, when the price rises above the upper limit of the market range (resistance zone) or falls below the lower limit (support zone), we can say that the price has broken out of the range, which is also a rectangular chart pattern.

The same is true for most other chart patterns—triangles, wedges, flags, and pennants—which may have horizontal or diagonal (trendline) boundaries.

In fact, all chart patterns, including head and shoulder/inverse and double top/bottom, involve some form of breakout.

Moreover, a rise in price above a previous swing high or a fall below a previous swing low can also be called a breakout as the price breaks through a previous resistance or support level.

Trading The Break After The Pattern Break (and Avoiding False Breakouts)

Breakout trading simply means entering a trade when price breaks above a resistance area or below a support area to capture the expansive price movement that occurs beyond that level.

This literally means buying high with the hope of selling high in an uptrend, or selling low to buy low in a downtrend, which is contrary to the traditional market principle of buying low and selling high.

Despite the controversy, breakout trading works in many cases. But why would anyone want to buy high and hope to sell high, or sell low and hope to buy low? The answer is simple and consists of two parts:

Breakout trading involves entering a trend that has already begun, and one of the principles of technical analysis is that a moving trend is more likely to stay in that direction than to reverse.

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There is a third answer: many legendary traders and market wizards, from Jesse Livermore and Ed Seykota to Richard Dennis and Bill Eckhardt, have used some form of breakout strategy.

Perhaps the most popular application of the breakout strategy was the Turtle Traders experiment, in which Bill and Richard taught beginners a trading method that included the use of breakouts.

But even with all the supporting factors, a breakthrough strategy is not the Holy Grail – of course, there never was one. Many breakthroughs fail almost immediately.

In fact, there are more false breakouts than real ones, but if you catch a real one, you can get a good reward for it.

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Nobody wants to get caught in a false breakthrough. When you fall into the trap of a false breakout, buying the high or selling the low will seem like the dumbest thing you can do.

Although there are many false breakouts, there may be a way to filter out breakouts that may fail. Here are some examples of breakthroughs that are more likely to fail than work:

A counter-trend breakout will likely fail as it is still a retracement move, which is typically weaker.

During an uptrend, it is not uncommon for a pullback to break below support, trap sellers, and then reverse to continue its climb higher.

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Likewise, a rally during a downtrend can break above resistance, trap early bulls, and reverse to resume the decline.

Although a breakout that occurs against the trend may indicate the beginning of a possible trend reversal, it is more likely that institutional traders are acting reasonably relative to retail traders and the trend is likely to continue.

The GBPUSD chart below shows a downtrend where the price broke through a support level which then became a resistance level.

In this GBPUSD chart, the price was in an uptrend. There were false breakouts below support levels.

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This occurs when price suddenly breaks through a known support or resistance level on the first try – a fast price move with obvious large momentum (tall candles) breaks the resistance or support level.

The obvious display of sheer size may make you think the move will continue and you jump (not wanting to miss out) only to see the price reverse almost immediately at a faster rate than it was moving – more like they were waiting for you to jump and you will fall into a trap.

But here’s the thing: when you see such an unexpected breakout, know that the price is extended and the move is erratic – the price did not initially accumulate enough energy to break through this level.

So it’s just smart money playing their game, trying to trigger stop orders and lure market orders so they can fill their own orders in the opposite direction.

Breakout: Definition, Meaning, Example, And What It Tells You

Now let’s look at situations where a breakout can work. But you should know that even in such situations, a breakthrough can and in many cases does fail.

So trade at your discretion and always use a stop loss. Here are the types of breakouts to watch out for:

General market wisdom is to trade in the direction of the major trend, and the same applies to trading breakouts.

According to Dow Theory, a market that is trending will continue to move in that direction until the trend is proven to have reversed. A breakout in the direction of the trend is a continuation of the trend.

The Importance Of Volume In Breakout Trading

As you may already know, in a trending market price moves in waves (oscillations)—stronger, longer impulse waves move in the direction of the trend, while shorter, weaker corrective waves (pullbacks) move in the opposite direction.

These swings tend to reverse at support or resistance levels, depending on the direction of the trend, but for breakouts in the direction of the trend, we are only interested in momentum swing reversal levels.

In an uptrend, impulse swings move higher and reverse at resistance levels, so when the next rally breaks above the previous swing high (resistance level), the move is in the direction of the trend and is likely to continue.

Here’s why: In an uptrend, traders typically place buy stop orders above a resistance level so that they can enter a trade when the price breaks the resistance level and continues moving higher.

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There are also stop loss orders for those who are short. The huge number of buy stop orders plus the new market buy orders that come in when a breakout occurs help push the price higher.

If this level is broken by the next decline, the decline will likely continue. The reason is that a huge number of sell stop orders (including previous buyers’ stop losses) lying below the support level will be triggered, and sellers who were previously on the sidelines will come out with huge market sell orders.

In the Apple chart below, the market was in an uptrend and the price broke through the resistance level. Notice the gap that occurred immediately after the breakout candle.

The chart below of the S&P 500 shows the Covid-19 bear market on the H1 time frame. Notice how the price broke through the support level.

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A breakout that is most likely to work will take time to build strength around a support or resistance level before the breakout occurs.

This can be seen by the number of times the price touches this level. Severe price consolidation could also occur at this level. In other words, the price will first cluster around the level it is trying to break.

Do you know why this happens this way? It takes time for the price to absorb all opposing orders lying at this level.

If this is a resistance level, there will be limit sell orders and take profit orders from previous buyers that the bulls must absorb before they can push the price higher.

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The fact that the price is concentrating around this level instead of turning sharply lower shows that the bulls are serious.

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