Trading breakouts in forex currency pairs can be profitable for traders who know how to properly implement a breakout trade. Breakouts can be to the upside as well as the downside, and they typically occur after a currency pair has traded in a well-defined range or chart pattern for a period of time.
In this article, Benzinga explains how to enhance your forex trading success by correctly identifying breakouts, as well as how to include a breakout strategy in your overall trading strategy to profit from a breakout once it has been observed.
What Does it Mean to Trade Breakouts in Forex?
As implied in the term used commonly among technical analysts and forex traders, a breakout refers to a situation where the market for a currency pair trades or breaks through a support or resistance level on an exchange rate chart.
Before a breakout occurs, the exchange rate typically trades in a consolidation or range trading pattern that helps traders determine the level from which the breakout will ultimately take place. Breakouts in forex currency pairs can be profitable to trade if they are quickly and accurately identified and the appropriate initial and follow-up trades are executed well.
How Does Trading Breakouts Work?
The first objective of trading a breakout is to enter the trade in the direction of the breakout as soon as possible after confirming the breakout move has occurred. The second objective is to exit the trade for a decent profit before the exchange rate corrects in the opposite direction.
Forex traders using technical analysis often pay special attention to nearby support and resistance levels or trendlines if they are waiting for a breakout to occur. Also, once a true breakout begins, a slew of forex traders watching the same chart points or trend lines tend to fuel the move. This follow-on activity propels the exchange rate further in the direction of the breakout.
If you trade forex using technical analysis, then learning to recognize and take action when a breakout occurs can be profitable as long as you take your profits in a timely manner. Also, since breakouts can fail, some conservative breakout traders use the so-called 3% rule that prevents a breakout trade from being triggered if the follow-on move is less than 3% of the market price or exchange rate.
Many prudent breakout traders also look at the trading volume that accompanies a particular breakout. Breakouts on high volume tend to show conviction on the part of traders, so the exchange rate tends to continue moving in its initial direction.
On the other hand, breakouts that occur along with low trading volume are more likely to fail because of a lack of conviction. Trading such breakouts can result in losses since the market often subsequently reverses its initial breakout move.
Types of Forex Breakouts
Breakouts occur when the market moves above a resistance zone or below a support region shown on an exchange rate chart, so a currency pair can make a breakout to either the upside or the downside.
In addition, breakouts can be categorized by whether they continue or reverse the prevailing trend as follows:
- Continuation breakouts: These breakouts result in the market moving further in the original direction of the previous trend.
- Reversal breakouts: These breakouts result in the market moving in the opposite direction to the previous trend.
Finally, breakouts can occur when the market breaks a trendline or from a classic chart pattern when one of its trendlines is broken. Chart pattern breaks typically set up measured move objectives that traders can use to set their profit-taking levels.
Trading Breakouts Effectively
Your chances of trading breakouts successfully can often be improved by taking the following recommended steps.
Importance of Having a Trading Plan
Having a well-structured forex trading plan to guide your breakout trading activities gives you a solid foundation on which to build your trading success. Ideally, your trading plan should be well thought out and contain prudent risk and money management guidelines you intend to follow when trading breakouts.
Identifying Potential Breakout Setups
Traders can review exchange rate charts to identify possible future breakout setups. They can then monitor the chart to watch for the actual breakout so that they can trade it according to their trading plan’s guidelines covering breakout situations.
Entry Strategies for Breakouts
Specific breakout entry strategies differ among traders, but it usually involves taking a position in the direction of the breakout once the breakout occurs. For example, a trader might see a trading range forming on an exchange rate chart and plan on entering into a long position if the range breaks to the upside or a short position if the range breaks to the downside.
Exit Strategies for Breakouts
Breakout exit strategies usually involve determining specific market levels at which taking profits and stopping out losses seem advisable on a position established based on an observed breakout situation. Chart patterns often have measured move objectives that traders can use to set their take profit levels as well as failure points that can be used to set stops.
Many forex traders put orders into the market at their preferred take profit and stop loss levels as soon as they enter into a position based on a breakout seen on a currency pair’s exchange rate chart. This process lets them have an exit strategy in place while they focus on other things.
Strategies for Trading Breakouts
Forex traders can use a variety of different strategies to trade breakouts. Some of the more popular breakout trading strategies include the following.
Trendline Breakouts
A trendline can be drawn between significant high points or between significant low points observed on an exchange rate chart. When the market crosses a major trendline, it can result in a substantial follow-on move in the direction of the breakout.
For example, consider a situation where the exchange rate for a currency pair has been trending higher overall by showing a series of higher highs and higher lows such that you can draw a clear trendline through the set of higher lows. If the market then falls below that rising trendline, a trendline breakout occurs to the downside.
You can potentially profit from this situation by selling the currency pair either immediately or on a bounce that moves up to retest that broken trendline. You can then aim to take profits once you establish a short position by entering a take-profit order at an objective roughly equal to the difference between the upper and lower trendlines projected downwards from the breakout point.
Support and Resistance Level Breakouts
You can often identify support and resistance areas on an exchange rate chart for a currency pair by looking for levels where the market tends to reverse. If the market repeatedly reverses lower at a particular level or region, you have found a resistance point that suggests substantial supply exists at that exchange rate level. Conversely, if the market repeatedly reverses higher at a particular level or region, that level marks a support point where substantial demand exists.
If a market move manages to gain sufficient momentum to finally overcome a significant support or resistance level, then the breakout can result in a substantial follow-on move in the same direction. Stops should be placed on the other side of the support or resistance point that has been broken, while profits can be taken when the momentum of the breakout move seems to wane.
Moving Average Breakouts
Many technical forex traders will plot one or more moving averages superimposed over the exchange rate chart. This indicator helps smooth out exchange rate movements so that the underlying trend can be more clearly seen.
Moving averages can also provide a breakout trading signal when they cross over each other or the exchange rate itself. A bullish signal is generated when a moving average with a short time period crosses above a longer-term moving average, while a bearish signal arises when a short-term moving average crosses below a longer-term moving average.
Pitfalls to Avoid When Trading Breakouts
Trading breakouts may seem like an excellent trading strategy, but it does have some potential pitfalls that a savvy forex trader will want to watch out for and avoid. The following sections mention some of the main problems that can arise when trading breakouts.
Overtrading
Overtrading occurs when a trader operates more actively than necessary in the forex market, often trading merely for the thrill of doing so rather than because their trading plan dictates a specific course of action.
Keep in mind that each forex trade executed has a cost associated with it from a commission you will need to pay or the dealing spread you have to pay away. Overtrading results in additional transaction costs, and it can also cause you to take excessive risks without a decent chance of earning sufficient rewards.
Failing to Manage Risk
Prudently managing the risks you take when trading is a key part of staying in business as a forex trader over the long term. When trading breakouts, make sure that you have a stop loss order level either placed in the market immediately when you take a position or firmly in mind if you intend to watch the position closely.
Neglecting a Trading Plan
Coming up with an excellent and well-thought-out trading plan that incorporates a tested trading strategy is an established route to success as a forex trader. However, taking the time to develop an excellent trading plan based on breakouts is basically worthless if you lack the discipline to stick to your plan through the various market situations you might encounter.
Should You Trade Breakouts?
If you are or plan on becoming a technical forex trader, then understanding how to trade breakouts makes sense as part of your basic technical analysis education. Breakouts provide a fairly reliable trading signal, and many successful traders make a good portion of their money from identifying and trading breakouts.
Frequently Asked Questions
What is a breakout in trading?
Breakouts are market events that occur when the market level moves beyond established support or resistance levels or outside of a chart pattern.
What is the 3% breakout rule?
The 3% breakout rule refers to a trading criterion where the market needs to rise above a resistance level or fall below a support level by 3% to confirm that a breakout has occurred.
Is breakout trading profitable?
Yes, breakout trading can be profitable, and many successful traders use breakout trading strategies to make money.
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About Jay and Julie Hawk
Jay and Julie Hawk are the married co-founders of TheFXperts, a provider of financial writing services particularly renowned for its coverage of forex-related topics. With over 40 years of collective trading expertise and more than 15 years of collaborative writing experience, the Hawks specialize in crafting insightful financial content on trading strategies, market analysis and online trading for a broad audience. While their prolific writing career includes seven books and contributions to numerous financial websites and newswires, much of their recent work was published at Benzinga.