Breakout trading consists of looking for moves “breaking out” of an established range. Price can be caught within a horizontal channel or it could be a triangle, trend line etc. The assumption is that once the consolidation boundary has been broken price will continue to move in the breakout direction for some time.
A few of the any reasons this method of trading can work:
• Self fulfilling prophecy. A high percentage of Forex market participants are speculative and will be trading technical methods.
• Momentum. Whatever is moving price in the direction of a breakout could easily continue i.e. large purchase of a currency by a central bank. A breakout trade is in the direction of the immediate trend.
• Other market participants forced to liquidate when stop losses hit/sell orders liquidated can add to the momentum.
Anatomy of a breakout trade.
Chart 1 show the trend line is in place with exact touches making this a noticeable area. It is important that other market participants notice this area if we are to believe the self fulfilling prophecy theory.
Chart 2 shows price initially breaking through the area. The success of a breakout depends on the order flow hidden behind the breakout area. An initial push through does not give strong momentum so this could go either way.
Chart 3 shows the market is buying into this move and the momentum can be seen as new buyers enter the market and sellers liquidate their positions.
London Open Breakout Trading
Many traders prefer to trade breakouts around the London open. A quick look at the following chart (source BIS) shows why this approach is often favoured. The London trading session accounts for a high percentage of all FX transactions.
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Different breakout trade entry methods.
1. The breakout is entered on an initial break of the trend line. Aggressive approach. No confirmation is required.
Pros. If the breakout works then maximum profit will be realised as we have bought in at the start of the move.
Cons. Prone to “fake outs”. Price triggers the entry and reverses hitting a stop loss. We may have inadvertently bought at the apex of the move.
2. Waiting for confirmation. Conservative approach. Wait for the market to close above a trend line and enter on the opening of the next candle or when the market shows continued momentum.
Pros. Avoiding a scenario where the market moves through the trend line then reverses leaving a wick (see shooting star and hammer or similar).
Cons. Missing some of the initial move and therefore gaining a smaller profit or even worse missing the profit target.
3. Price action confirmation. Conservative approach. Using price action to confirm an entry. This can be price action tipping its hat to an impending move or a retest and continuation move.
Pros. The right price action confirmation can be excellent for avoiding fake outs.
Cons. Discretionary method needs experienced practitioner to trade effectively.
Breakout pullback continuation trading
The breakout, pullback and continuation based entries are another popular trading entry strategy. A blind entry as price breaks out of an area can sometimes lead to a whipsaw false breakout scenario. The attached chart shows how price attempted to move through the descending trend line on the 3rd swing high attempt and then dropped strongly to the downside taking out many longs.
Traders using breakout pullback and continuation entries often look for price action at the breakout trend line. The attached chart shows a hammer candle at the breakout trend line. The trader would enter and look for price to once again resume the upside move after finding price action support at the trend line. The added confluence on this chart of a 61.8% pullback and loose price pivot zone add weight to a long trade idea.