What is a breakout in forex?
Breakouts are one of the most common trading strategies. They involve identifying a critical price level you expect o break through and then buying or selling at that price to take advantage. Generally, breakouts are used when the market is already near the extreme high or low of the recent past.
Traders who trade breakouts live by the motto, “No price is too high to buy, and no price is too low to sell.”
Because not all traders recognize or use the same support and resistance levels, breakouts can be subjective.
Breakouts indicate the potential for the price to start trending in the breakout direction.
A breakout to the upside indicates that the price will start trending higher. This signals traders to possibly go long or exit short positions.
Once the resistance level is broken, it reverses its role and becomes a support level if the price experiences a correction or pullback.
A breakout to the downside also called a breakdown, is that the price would start trending lower. This signals traders to possibly go short or exit long positions.
Once the support level is broken, it reverses its role and becomes a resistance level if the price experiences a correction or pullback.
Breakouts that occur on HIGH volume (relative to average volume) show greater conviction which means the price is more likely to trend in that direction.
Breakouts that occur on LOW volume (relative to average volume) show weak conviction and are more prone to failure. Price is less likely to trend in the breakout direction.
How to Trade Breakouts
A breakout occurs because the price has been contained below a resistance level or above a support level, potentially for some time.
The resistance or support level becomes a line in the sand that many traders use to set entry points or place their stop losses.
When the price breaks through the support or resistance level, two things usually happen:
- Traders are waiting for the breakout to jump in.
- Traders who had placed their stop losses in this area get stopped out.
This surge in buying and selling will often cause the volume to rise, which shows that many traders were interested in the breakout level.
Breakouts are commonly associated with chart patterns, including rectangles, triangles, wedges, and pennants.
These patterns are formed when the price moves in a certain way that supports and develops resistance levels.
These levels are monitored heavily by traders.
If the price breaks above resistance, traders go long. If the price breaks below support, traders go short.
After a breakout, the price may, but not always, retrace to the breakout point before moving in the breakout direction again.
After an upside breakout, the price may retest its previous resistance level, which has now turned into a support level.
After a breakdown (downside breakout), the price may retest its previous support level, which has now turned into a resistance level.
This happens because some shorter-term traders will often buy the initial breakout and then quickly take profit.
To exit their extended position, they must sell. This selling temporarily drives the price back to the breakout point.
If the breakout is genuine, then the price should move back in the breakout’s direction. If it doesn’t, it’s a “fakeout” or “failed breakout“.
Fakeouts do occur regularly.
The price will often move just beyond resistance or support. This tricks the gullible breakout traders into entering.
The price then reverses and fails to continue moving in the breakout’s direction.
This can happen multiple times before a real breakout happens.
Trading breakouts is not easy.
Trading chart patterns like triangles, flags, and pennants provide higher probability breakouts than ranges (or rectangles).
Since ranges are easier to identify, this means fields attract traders who have opposite approaches:
- Breakout traders
- Range traders
In this scenario, opposites do not attract. They create fakeouts.