Breakout trading stands as a steadfast strategy that has captured the attention of seasoned investors and aspiring traders alike due to its potential to capitalize on significant price movements right from the start of a new trend formation.
The breakout strategies aren't just another passing trend; it's a strategy grounded in the fundamental principles of market psychology and technical analysis. At its core, breakout trading offers traders a way to identify entry and exit points because significant price movements often occur after established support and resistance levels are breached.
Simply put, there are endless trading opportunities day in and day out.
And navigating this landscape can be challenging, especially for beginner traders who don’t know how to read a price chart or when to enter a trade.
In this detailed guide, we’ll provide you with a logical progression through the world of breakout trading. We will begin by demystifying the anatomy of trading breakouts, laying the foundation upon which your expertise will be built, and from there, we will delve into the intricate tools and breakout indicators that serve as your compass in deciphering market dynamics.
Next, we explore various breakout trading strategies, each tailored to different market conditions and scenarios. Through detailed explanations and real-world examples, you will gain a comprehensive understanding of how to approach support and resistance breakouts, chart pattern breakouts, and volatility breakouts with finesse while developing the acumen to differentiate between true breakout signals and false breakouts.
What is Breakout Trading?
A breakout in the realm of Forex trading occurs when the currency price moves beyond a predefined support or resistance levels, often accompanied by a surge in trading volume, signaling a shift in the market momentum.
Source: TradingView EURUSD Breakout Trade Example
The breakout trader adeptly seizes the opportunity, opting for a long position as the currency pair's price breaches above a resistance level or alternatively, embracing a short position when the currency pair's price plunges beneath a support level.
The breakout trading setups are also important because they are the catalyst for:
forthcoming spikes in volatility,
substantial oscillations in price,
and often, pivotal price trends could unfold.
Breakouts, as a phenomenon, materialize across the spectrum of market environments.
Notably, the most explosive surges in price are often the product of consolidation breakouts, channel breakouts, and chart pattern breakouts such as head and shoulders, triangle patterns, flag patterns, double top and double bottom patterns, wedges, etc.
Source: TradingView USDCAD Head and Shoulder Breakout Entry
The profitability of the breakout setup is the same across all timeframes whether you’re using the 5-minute, daily, or weekly charts, and whether you’re a day trading, swing trading, or trend trading, a breakout typically signals a price expansion in the direction of the break (up or down).
Type of Breakouts in Forex
Breakouts in Forex trading can be classified into two overarching classifications, each reflecting a distinct market sentiment and directional trajectory:
Continuation breakouts
Reversal breakouts
Continuation breakouts come into play when the market's surging trend pauses, taking a momentary breath within the confines of consolidation, and then a breakout emerges in the direction of the prevailing trend.
Reversal breakouts happen when the price breaks out of a trading range moving in the opposite direction of the prevailing trend.
Source: TradingView Gold continuation breakout vs reversal breakouts
However, trading breakouts in Forex extend beyond the classic support and resistance breakout trading system and are imbued with multifaceted dimensions, each offering a distinct avenue for exploration:
Breakouts of old swing highs and lows.
Breakouts of psychological numbers
Breakouts of moving averages
Breakouts of channels
Breakouts of technical indicators.
Breakouts of Fibonacci levels.
Breakouts of chart patterns.
Breakouts of trendlines.
Momentum breakouts.
Breakout trading can even be applied to fundamental data.
The Anatomy of a Breakout Trading Setup
Delving into the fascinating realm of breakout trading setups unveils a key truth: the bedrock of your strategy lies in understanding the concept of support and resistance levels.
What are Support and Resistance Levels?
Support and resistance levels serve as the architectural framework for your trading endeavors.
Picture support as the unwavering "floor" beneath prices, a realm where buyers rally and prices find stability. On the flip side, resistance stands as the steadfast barrier that prevents prices from soaring further.
Now, let's unveil a golden nugget of wisdom:
The strength of these levels isn't merely a numbers game.
It's all about touchpoints.
The more frequently a currency pair touches these SR zones, the more their significance grows. These levels transform from mere lines on the chart to pillars of trading insight, and here's the kicker: the longer these levels have endured, the sweeter the victory when the price finally takes the plunge and breaks free.
Source: TradingView USDJPY Breakout Trade Example
What are the Best Breakout Trading Indicators
While the notion of a single "best" indicator remains a mythical quest, these trading tools can serve as your allies, both as entry confirmation tools and as timely entry signals.
Breakout trading indicators like the RSI (Relative Strength Index), Volume indicators, and moving averages can be used by breakout traders to filter out genuine breakouts from false breakouts.
RSI Confirmation for Trading Breakouts
The RSI indicator can be used to trade breakouts as both a confirmation tool and a divergence signal.
Confirmation materializes when the RSI line and the currency price harmoniously move in the same direction. A glance at the GBPUSD chart below offers us further insights.
Source: TradingView GBPUSD RSI Breakout Trade Example
As the price embarked on an upward trajectory, so did the RSI, mirroring the prevailing trend, and when the breakout occurred, the RSI wasn’t in overbought territory signaling potential further upside movement in the direction of the breakout.
The breakout trading example below highlights how to use the RSI divergence signal to protect yourself against false breakouts or “fakeouts.”
Source: TradingView EUR/USD False Breakout Example
The EURUSD currency pair broke below the support level but at the same time, a bearish RSI divergence unfolded as the price was making a lower low (LL) while the RSI oscillator printed a higher low (HL) warning breakout traders against entering the market.
As the chart attests, the price reversed shortly and returned to the prevailing consolidation pattern confirming that this was a false breakout signal.
To limit the downside risks of fakeouts, breakout traders can also employ hedging strategies.
How do you Trade the Breakout Trading Strategy?
Embracing the breakout trading strategy holds the promise of lucrative gains, yet the shadow of a false breakout looms large which is why breakout traders need to use strict risk management rules with a minimum risk-to-reward ratio of 1:2.
Breakout Entries
When it comes to seizing positions within the confines of a breakout, the entry points are straightforward.
There are 3 broad types of breakout entries in trading:
Entry without confirmation quickly right when the price breaks away.
Entry with confirmation once the price closes above/below support and resistance levels.
The breakout pullback entry.
Breakout Exits
Establishing predetermined exit points is crucial for effective breakout trading. Here's how to approach it:
Setting Target Prices: Determine a realistic target price by analyzing recent price action and considering the currency pair's behavior. For instance, if a recent price pattern indicates a range of 100 pips, you might set this range as your target.
Defining Stop-Loss Levels: To manage risk, set stop-loss orders below support (in the case of a long position) or above resistance (for a short position). This approach helps you limit potential losses if the trade doesn't go as planned.
Adapting to Failed Breakouts: Exiting with Caution
Not every breakout will result in a profitable trade. When a breakout fails and the price returns within its previous range, it's important to have a clear exit plan. Old resistance levels can act as new support, and vice versa. Use these levels as reference points to determine when to close a losing trade.
Breakout Trading Strategies Examples
A simple breakout trading system aims to enter a trade as soon as the price breaks out of its established range and there are a few trading strategies that can help traders capture strong rallies and sell-offs as soon as they happen.
Simple trading strategies that look to buy and sell breakouts are:
ATR Channel Breakout strategy.
Bollinger Channel Breakout strategy.
The breakout-pullback strategy.
The RSI trendline breakout strategy.
Chart pattern breakout strategies.
200-day MA breakout trading strategy.
Etc.
For example, the Bollinger Bands breakout strategy utilizes the Bollinger Bands indicator, which consists of a moving average and standard deviations above and below it.
A breakout is signaled when the price closes above the upper Bollinger Band or below the lower Bollinger Band and this strategy seeks to capture price movements beyond the typical range.
Source: TradingView AUDUSD Bollinger Bands Breakout Strategy
What are the Pros and Cons of Breakout Trading
The breakout trading strategies come with their fair share of advantages and disadvantages.
Pros:
Quick Profits from Swift Market Movements.
Simplicity in Entry and Exit Points.
Price Action-Centric.
Breakout Points are Easy to Spot.
Cons:
There are many False Breakouts or Fakeouts.
Breakout Traders Need to Be Fast Thinkers and Make Quick Decisions.
The Breakout Strategy has a Low Win Rate.
The path to success in the Forex market begins with the right Forex broker by your side. Breakout traders understand the importance of lightning-fast execution, which is why you need to explore, evaluate and compare the best Forex brokers that offer fast order execution, ensuring that your breakout strategies are executed with precision, efficiency, and without slippage.
