By: Terry Allen
Breakout Trading is considered to be a very lucrative Forex Strategy because it provides excellent reward-to-risk ratios. However, dangers still lurk because even powerful movements such as breakouts can suddenly reverse transforming themselves back into fakeouts.
In order to profit from this type of trading, you need to devise a method that can help you differentiate breakouts from fakeouts. To achieve this, you must first be able to identify when a breakout is likely to occur. These events usually happen after the market has been trading within a tight consolidation phrase for some time. There are a number of trading patterns that you can use to identify such formations.
The first is called range trading whereby price has been oscillating between a ceiling or resistance and a floor or support. The difference between the upper and lower levels is quite often relatively small. Under these circumstances, a breakout eventually occurs when price bursts through the ceiling on a bull breakout or through the floor on a bear one. If the support is broken, it then becomes the new resistance, whilst if the resistance is broken it becomes the new support.
There are two other main consolation patterns called the pennant and the flag. The former creates a triangle shape whilst the latter a rectangle. Both patterns are created after a price surge consolidates into a sideways movement.
The rectangle shape of the flag is formed by two parallel trendlines with the top one functioning as resistance whilst the bottom acts as support. The flag will not normally be flat as its trendlines tend to slope in the opposite direction to the initial price movement. A buy or sell signal is usually generated if the currency price breaks through either resistance or support and resumes the direction of the original price trend.
In contrast, the pennant adopts the shape of a symmetrical triangle where the support and resistance trendlines converge onto each other. Unlike the flag, the pennant is normally flat and its direction is of less importance.
Both the flag and pennant are particularly good as gauges of breakouts if the price surge before their creation was very strong.
Upon a bull breakout the following is usually true about all three consolidation patterns. The previous resistance becomes the new initial support; the mid-distance between the trendlines becomes second support whilst the old pattern support becomes the third level support. The opposite is true for a bear breakout. These new support and resistance points are very useful in determining your stop strategy.
How to profit from these patterns will be shown in the next article.
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