Breakout Trading System
Breakout trading strategies are used when entering the market while prices have broken through resistance/support levels. There are various different breakout strategies and they're employed in all financial markets.
Breakout strategies are particularly common among newbie forex traders, because they are simple to understand and carry out. The basic idea is to enter the market the moment the price breaks through the channel and begins trading outside it. A frequently used technical signal for spotting breakouts is the Bollinger Bands indicator.
When the price breaks higher than the upper or lower Bollinger Band, it is observed as an increased chance of a breakout.
In its most basic form, a breakout trading strategy requires placing a buy stop or sell stop either above the resistance or below the support level. A buy stop is an order for a long position that is mainly filled when a particular price is reached. A sell stop order operates the exact same way, but in this specific case a short position is opened when a given price is reached.
Example Of A Breakout Trading Strategy
Suppose the currency pair EUR/USD has shifted in a range between 1,4300 and 1,4500 for the last few days.
The 1,4500 has shown to be an critical resistance level, and the 1,4300 and important support level. The trader at this point places a buy stop order at $1,4510 and a sell stop at $1,4290. This indicates that if the price breaks the 1,4500 and touches the 1,4510, a long position would be opened that can profit optimally through a bullish breakout. In the similar fashion a short position might be opened if the price breaks 1,4300 and touches 1,4290.a short position would be opened if the price breaks 1,4300 and touches 1,4290.
Different Types Of Breakouts
There are typically two kinds of breakouts, the continuation breakout and the reversal breakout.
- Continuation breakout: a breakout is known as a continuation breakout when the price remains to move in the course it was moving before an interval of consolidation. Think of a short-term price range, when buyers and sellers wind down their positions and attempt to forecast which way the price will go. The oil price graph above demonstrates an example of a continuation breakout.
- Reversal breakout: A reversal breakout is the starting out of a real trend reversal. In other words, the price progress breaks with the earlier trend and starts trending in the reverse route. This is typically a result of changed fundamentals. See the oil price chart for a reversal breakout example also.
Naturally the reversal breakout is scarcer than the continuation breakout, merely because trend reversals on their own are much less frequent than the continuation of an established trend after a (usually short) period of consolidation.
You can find all sorts of breakout trading strategies, both for the intra-day trader and the long-term forex trader who puts on positions for weeks, months or perhaps years.
The most significant sign of the breakout trading strategy is that the currency pair has to have departed the channel it had been moving in. To identify the range of the channel you have to check out its resistance and support levels.
There are numerous techniques to gain knowledge into the resistance and support levels, the most basic of which is open to everybody.
For example, take a candlestick chart of the 10 minute EUR/USD (where every candle symbolizes 10 minutes).
Now examine the high and low for a period of about 20 – 30 candles, and decide if they have been reached (but not broken) multiple times. If the answer is yes, you could claim that short term resistance- and support levels are established by that respective high and low. If this high or low is broken, it would be a breakout.
The central element of each breakout trading strategy is joining the market when the price breaks through a certain resistance or support level, i.e. from its ‘normal' channel (remember the Bollinger Bands). Breakthroughs like that can be the start of very profitable trades.
So how come breakout trading strategies aren't the holy grail of trading systems either? The answer is clear: because not all breakouts push on. Believe it or not, most breakouts don't push on. So called ‘false breakouts' break through resistance and support levels, but are unable to hold on to their energy; they can't force a continual break. (a few traders say that a break is a break when the price goes through a resistance/support barrier, but most traders create a differentiation between technical breaks and sustained breaks).
In particular, when the EUR/USD has been incapable to break the 1,4448 in two consecutive attempts but the third time a brief spike pushes it to 1,4451, does that suggest resistance has been broken? Technically yes, but nearly all of the time the resistance will still jump into action and drive the price back, since many traders put on positions against the breakout the moment resistance/support has become broken. Trading strategies depending on this are known as breakout fading strategies, because they hypothesize against the path of the breakout.
Testing A Breakout
Certainly you don't want to open a position intended to gain from a breakout when there is a huge chance of it being a false breakout. To reduce this chance you could initially test if the breakout is real. The two most frequently used techniques for this are secondary resistance/support levels and role reversals, which we will be looking at now.
- Secondary resistance/support levels. Basically, this is nothing more than choosing on a second line of defense the price has to break, before the break of the first level is regarded as a success. To do this you examine the charts you use for your trading strategy. When you're an intra-day trader for example, rarely keeping trades open longer than an hour or two, you could perhaps look at the 5 minute candlestick chart. For an intra-day trade on the EUR/USD, a second line of defense of about 15 pips above the specific resistance/support is a sign that a breakout may stay longer.
- Role Reversal. This is the change from a broken resistance into a support (along with a broken support into a resistance). The concept is as straightforward as it is refined. When the price breaks through a certain resistance, that resistance immediately turns into a new support. If the price retraces but doesn't break the latest support, it's a signal that the breakout is authentic, because the price has not came back to the channel it was in before the breakout.
It's very typically the case that the price pivots around recently established support/resistance levels, but each time there is a bounce off (i.e. the price touching, or nearly touching the limit, but not breaking through) it's a much better sign that the new support/resistance is set up and the breakout is real.