Some traders prefer to use breakout points to signal their trend entries, others prefer to use indicators which just show strong directional momentum. Who is right, and which works better?
There are several different momentum indicators that all calculate price momentum, allowing the indicator user to see at a glance whether a particular currency pair is showing strong momentum long or short, or is simply chopping and ranging sideways with no momentum at all.
Technical analysts have developed a wide range of such indicators that are broadly available for free on almost every trading platform. The most popular are moving average crosses, the Relative Strength Index, MACD, Bollinger Bands, and Stochastics. What all these indicators do is basically look back over a determined period of time and calculate whether the price movements have been more bullish or bearish. The internal formulas used by each indicator to calculate the indicated output are conceptually similar. In my opinion, the RSI is the best performer.
Momentum traders tend to largely ignore support and resistance and simply check to see whether momentum indicators show the price is more bullish or bearish on both shorter and higher time frames. When both types of time frames are showing momentums which agree, a trade in the direction of the prevailing momentum is taken.
Another approach that can be taken, which may be either in replacement of the use of indicators or complementary, is to draw key support and resistance levels and watch to see if they hold or break. For example, if resistance levels keep getting broken while support levels hold, it would show that there is bullish momentum.
There is another way to achieve the same kind of entry with strong momentum, and that is to enter a long trade when the highest price recorded over a certain time period is broken. This is a very well-known and time-honored trend trading approach. In fact the famous Turtle Traders used an entry method based upon breakouts of 20 and 55 day high or low prices (these prices are shown by the Donchian Channels indicator).
This kind of approach is very attractive as it is extremely simple and consumes no time, it is a “set and forget” mechanical trade entry. For example, at the end of each day, you can simply enter an order with your broker to go long or short at X and Y prices, which are known to you as the highs and lows of the given look-back period, and then you do not have to worry about it for another 24 hours or so.
It is widely believed that these kind of crude mechanical strategies based on breakouts are too brainless and do not produce good results. In modern markets, there are many more “fake outs” than “successful breakouts”, particularly in Forex prices which tend to move in tighter ranges than stocks and commodities.
A key thing to remember that might counter this perception, is that exactly what constitutes a successful breakout is very much open to debate. For example, the price breaks out, moves favorably for a few pips, and then moves adversely for 100 pips. Is this a failed breakout? The answer to that question really depends upon where you put your stop loss. If you put it at 50 pips, the breakout was a failure, producing a losing trade. However if you had used a wider stop loss, which might be a component of a volatility-based complete trading strategy, and the price had come back after its 100 pips drop and then gone on to rise 1000 pips, it would have been a successful breakout for you.
Traditionally, a stop loss of three multiples of the Average True Range is used in trend trading, which also often uses breakouts for entries. Of course, using a stop loss this wide will tend to produce more winners, but the size of the winners will be smaller than if tighter stops had been used.
A Comparison of Breakouts and Momentum Indicators
We can try to determine which of the entry strategies outlined above might generally work better in Forex trading by performing a back test on the same currency pair using the two different trade entry methods with the same stop loss system.
Let’s look at the EUR/USD pair over a period from 2001 to 2014. The stop loss used in each trade is always half of the 20 day Average True Range.
In the momentum indicator method, a trade is entered when at the close of any hour:
The price is the same side of where it was both 1 month and 3 months ago.
The 3 EMA is the same side of the 10 SMA on the H1, H4, D1 and W1 time frames.
The 10 period RSI is the same side of 50 on the H1, H4, D1 and W1 time frames.
All of these indicators must be bullish or bearish at the same time before a trade can be entered, showing strong directional momentum exists.
The results were as follows:
With a reward to risk target of 2 times the stop loss, there was an average positive expectancy of 6.2% per trade.
With a reward to risk target of 10 times the stop loss, there was an average positive expectancy of 39.6% per trade.
Now let’s take a look at the Donchian Channel breakout method. A trade is entered long the first moment during a day when the price trades above the high of the previous 80 days, or short when trading below the low of the same time period, provided that the stop loss level was not hit before the trade was entered. The period of 80 days is widely considered to be a good measurement of the best momentum breakout in Forex.
With a reward to risk target of 2 times the stop loss, there was an average positive expectancy of 11.72% per trade.
With a reward to risk target of 10 times the stop loss, there was an average positive expectancy of 42.68% per trade.
We can see that there was not much difference at the higher end of 10:1, but that breakouts did produce a better result at the lower end. Needless to say, there were far less breakout trades overall.
One reason for this is that it has been well established for centuries that prices tend to move easier when they are in “blue sky”, i.e. areas where the price has not been for a relatively long time.
Finally, note that it mattered little which precise entry strategy you used if you were going for the big moves of 10:1. This just goes to show that traders tend to worry too much about entries, whereas the real challenge is to hold on for large profits instead of being shaken into premature exits. As Jesse Livermore said, “I made more money by sitting tight than I ever did by being right.”