Breakouts occur when price has been range-bound for a period of time as bulls and bears battle to dictate the direction of the trend. Breakouts can either represent a continuation of the trend, after a period of consolidation which results in the formation of a rectangle chart pattern or at the end of a move higher or lower as a reversal. They can be seen on most timeframes and often result in price moving sharply higher or lower as either bulls or bears finally get the upper-hand. The general rule of breakout trading is that the longer the period of consolidation the more powerful the breakout is likely to be. Having said this, forex traders need to be wary of the potential for “false breakouts” which leave traders trapped on a break which quickly reverses and moves in the opposite direction.
Trading pattern breakouts
There are a number of methods to trade breakouts and many of these agree that the breakout needs to be confirmed in order to avoid a “false breakout” situation. When the breakout setup shows a rectangle pattern, with both highs and lows forming horizontal support and resistance lines, traders will wait for either level to be broken. This will provide the entry either directly at the high of the breakout price bar or, as many forex traders prefer, after the first pull back following the breakout. The reason that traders should wait to trade following the breakout of the rectangle is to reconfirm that this is a genuine price movement and that the momentum exists in the market for the breakout to be successful.
Other pattern breakouts include triangles and flags/pennants which all trade within a range before breaking out as a continuation of a reversal of the trend. Sideways price ranges can also be viewed on higher timeframes as “inside bar” patterns using candlestick analysis. The formation of inside bars represents market indecision and consolidation and several inside bars can result in a powerful breakout move.
Support and resistance in breakout trading
Breakout trading is all about waiting for price to break through an area of support or resistance that has been re-tested several times. As with all breaks of support and resistance levels, once price has moved past these the support levels become resistance and vice versa. In breakout trading this also applies and the point at which price breaks out will often be re-tested after the breakout to test if it will become a new support or resistance level. Using this knowledge, some of the highest-probability trades are the combination of candlestick analysis on the retest of the breakout. Once the new support or resistance level has been confirmed then traders can buy or sell with confidence in the direction of the breakout.
When a breakout occurs with strong initial momentum, there is a high possibility that it could be a false breakout. Market makers know that such a push beyond the breakout level will trigger a high number of trades and a reversal will trap a large number of traders with losing positions. Being aware that these false breakouts are common, some traders choose to ‘fade’ the initial breakout for several pips profit. Although this is an advanced strategy for trading breakouts, the understanding that price frequently returns to retest the breakout area provides an opportunity to trade the pull-back from a strong break out. Additionally, trades can be taken once the breakout failure has been confirmed; this will often result in a complete reversal and moving out of the consolidation area in the opposite direction.
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