Forex Trading Breakouts

 By Dianne L. Fecteau

Breakouts happen when price moves beyond support or resistance or violates a trend line. They’re an alert that something has changed—the balance of buyers and sellers has shifted or the trend is resuming or reversing. They limit the potential loss since stops can be placed just inside the breakout range.

Many breakouts fail. As Forex traders, it’s important to confirm the price movement before trading. You want evidence that the breakout is real.

Traders use various methods for confirmation. One is to wait for the close of the candle where the breakout takes place. Some traders wait for two candles to close. This is not fail-proof especially in a short-term chart.

Other traders wait for price to move a certain number of pips beyond the breakout. Using Average True Range (ATR), the average pips the pair moves in a given time period, can help determine that number. If the average is 10 pips in a fifteen-minute period, for example, the trader would enter when price exceeded that amount.

A look at the USDCHF 15-minute chart below shows the shortcoming of both methods. There are five total breakouts. In the first two, waiting for the close of one or two candles wouldn’t have assured a safe trade. Two candles closed above resistance in what looked like a vigorous upward breakout. Later, three candles closed below support. Using number of pips based on ATR would have resulted in the trader entering both trades since ATR was less than the breakout amount. In addition, the high volatility surrounding this pair would likely have resulted in slippage, increasing the loss amount.

Some traders mix time and price—e.g. the second candle that closes beyond the breakout has to close further away than the first one does. The combination increases the reliability. This approach would have kept the trader out of all breakouts except the last one in USDCHF.

Another method is to let price breakout and then return back to the breakout point before trading in the direction of the breakout. While the first four breakouts would have resulted in losses, those losses would have been small since the stop would be immediately inside the zone from which price broke out.

Perhaps most important is to stay aware of total price action and typical price behavior before trading a breakout. For example, breakouts tend to take place after a period of consolidation. What was price doing before the consolidation? In the case of USDCHF, price was trending down. That suggests the need for caution on the first upward breakout. The volatility around the breakout is also suspicious. It suggests a news event might be responsible. Breakouts can happen on news but they’re often reversed. After the large upward spike, the second break downward, within the hour, should have signaled that the pair was reacting rather than behaving normally. Finally, one can verify the breakout on a larger time frame. Breakouts on a 15-minute chart can be checked against the action on the hourly chart.

The five breakouts in USDCHF confirm how tricky breakout trading can be. But by the last breakout, the trader has hints price pressure is upward. The second candle is strongly bullish. It closes further away than the first one did. This breakout is still unfolding as I write this but it looks promising.

Take a look at a breakout that’s more straightforward. In the GBPUSD one-hour chart, the pair was in a strong uptrend before consolidating. Price broke out with a strong candle. The second candle retested resistance but its close was solidly above the first candle. The breakout in the direction of the prevailing trend offered reassurance that this breakout was meaningful.

Breakouts can be profitable which is why many trading systems are based on them. However traders must confirm the breakout and consider the overall price behavior.

© Dianne Fecteau, 2009.