The Breakout: What is it and how is it traded?
Breakouts are a very regular occurrence in the forex market, and their occurrence has major implications for the price action of the currency pair and by extension, the trader's positions in the market.
A breakout is defined as a price movement that breaks through an identified level of resistance or support, usually accompanied by heavy trade volume and greater volatility. The occurrence of a breakout is a sign of a major shift in trader sentiment.
For us to even talk about a breakout, we must talk about resistance and support. The price action of the currency pair must have struck a particular price barrier repeatedly without success to form an identifiable point of resistance (upside) or support (downside). The resistance and support levels form because traders have formed a sentiment of where the asset may be headed, but the sentiment is not strong enough to take the price of the asset to a particular level, or beyond a particular point.
Once a break has occurred through a point of support, that support now becomes a new resistance. Likewise, an area of resistance which has been breached by the price action in a breakout move now becomes the new support. Some authorities prefer to use the term “breakout” for upside breaches of resistance and the term “breakdown” for downside breaches of support. However, the fundamentals remain the same.
How to Trade a Breakout
If you want to trade a currency pair based on a breakout, you must be sure that what you are about to trade is actually a breakout and not a “fakeout”. A fakeout is actually a false breakout. Many traders get caught out trading what they think is a breakout, but which is actually a fakeout.
A typical fakeout situation is when the price action of the currency pair breaches a support or resistance point, but the key difference is that the candlestick in view DOES NOT close above (resistance) or below (support) these points. This is why it is necessary to look at the time frame in question. Is the chart a one hour chart? Then a single candle represents the price action for one hour. A candlestick on the 15 minutes chart represents the price action for 15 minutes, and on a daily chart, a candle is a whole day's price action. So before trading a breakout, you must ensure that the price of the asset has actually broken through the key level in question.
For a resistance point, a fakeout occurs if the price of the asset breaches to the upside, but eventually closes below the resistance. A true breakout here is when the candlestick breaks above the resistance point and closes above it.
For a support point, a fakeout occurs if the price of the asset breaks to the downside, but eventually closes above the support. A true breakout occurs here when the candlestick breaks below, and closes below the support line.
Now that we have defined the breakout and the fakeout, how can a breakout be traded?
a) One of the popular ways is by setting a stop entry order above a resistance and below the support. The Buy Stop or Sell Stop must be set at a good distance away from the key level. This is not my favourite way of trading a breakout as this method has a huge snag. It is possible for a long candle to breach the key level of support or resistance, trigger the stop entry order, and then retreat below the resistance/above the support, turning the trade into a fakeout trade. Such trades almost always end up on the losing side. Moreover, many traders who set the stop order entries have to do so at a considerable distance so as to avoid the fakeout scenario, and they end up giving away many pips or experiencing losses.
b) My preferred method of trading a breakout is to wait for the candlestick to break above the resistance and close above it, or break below the support and close below it. Once this has occurred, we can be sure that a breakout is on the cards. Usually, buyers will try to force the price back above the old support, and sellers will try to force prices below the old resistance. However, these moves will be resisted at the old support now turned resistance, and by the old resistance now turned support. I would sell at a support turned resistance, and buy at a resistance turned support. If you are watching the charts actively, you can wait for the scenario to occur and use market orders. If not, use a Buy Limit and a Sell Limit AFTER the breakout confirmation as shown below: