A breakout is a price motion that occurs in a different direction or pattern as compared to the previous price activity in the forex markets. By this it means that it can be a change from an uptrend to a downtrend or from a downtrend to an uptrend. Also, it can be a price movement above a well-established support or resistance level. You notice that when the prices move past the established supports and resistances it has changed the pattern but still in the same trend direction.
Breakouts can be further described as the break out from a Point of Agreement. Where the Point of Agreement (POA) is when there is a momentary balance in forces on a commodity price.
Looking at the screenshot above you can see that the market reached at a certain point where it started to rise to new highs as compared to previous highs. At this point we can say that there was a breakout.
However traders should be cautious to determine whether the breakout is genuine or fake. If you enter a trade anticipating that the breakout is genuine and it turns to be a fake one then you will automatically get losses. This can be done by determining the volatility of the market.
How to measure volatility
Volatility is the measurement of price deviations. Large price changes indicate high volatility while smaller price movements show a low volatility. For traders this price movements are what bring profits. Therefore the higher the market is volatile the higher the chances of making profits. But one should be careful since this high volatility also possess the danger of trends changing and if they do, they change in a huge manner and this can result to huge losses. This is what is referred to as price reversals.
Due to the risk of reversals, it’s a good trading practice to know how to manage risks. This can mainly be done by using stop loss and take profits. The stop losses will minimise your losses in case of the reversal while the take profit will ensure you pocket the cash you had targeted and you are out of the market. Also you may opt to use trailing stops.
Volatility can be measured by looking at a stock’s range which is the difference between the high and low price on any given day. The large ranges indicates high volatility and small ranges indicates low volatility.
The range= high – low (The highest prices in the duration being considered minus the lowest prices in the same period)
However, using the daily range is an inadequate measure of volatility given the limit moves and the daily range gaps that are indicated. Due to this a trader can use some of the indicators available.
The best and most commonly used is the Average True Range indicator that works on obtaining the true range which is the largest value found by solving the following three equations:
- TR = H – C.1
- TR = H – L
- TR = C.1 – L
Where: L represents today’s low, TR represents the true range, H represents today’s high and C.1 represents yesterday’s close
The indicator then calculates the average true range (ATR) which is an exponential moving average of the true range.
Types of breakouts
There are four types of breakouts. These can either be upside breakouts or downside break outs.
The Legitimate Breakout.
In this case the price rises or falls instantaneously without retracing for quite a period of time. However, it might pullback for a few bars after which it continues moving up and away until the trend ends. This is usually good news to every trend trader.
If you look at the EURUSD weekly chart above, there is a breakout from where the arrow is and the movement continues without major Retraces.
The breakout with Retrace.
In this case the price breaks out slickly just as in the legitimate breakout. However, price slides back to the breakout area somehow. As a trader if this do happen give it time to see if it repeats 2 to 3 times then you can be assured of opening a trade. However use risk management strategies to shield yourself from the risk of the trend changing.
From the above daily chart of GBPJPY, there is a breakout at the red downward arrow. From this point the trend reverses from upward to downward. Then it retraces severally at the yellow arrows.
The Fizzle out.
Price breaks out and then stalls. It’s just there going up and down with no large movements from the specific positions.
The Fake out.
In this case price breaks out to new highs or lows and instantly reverses. Therefore if you had entered a long term trend without stop losses, take profit or trailing stops you are 99% likely to get losses.
How to trade breakouts using trend lines, channels and triangles
- Trend Lines
They are drawn to help in spotting possibility of breakouts. They are drawn by clicking the trend line button in the mt4 platforms then clicking the start to the end of the trend you are considering. This start and end is mostly chosen to be tops and bottoms. In between the two outer top and bottom connected there may be other tops and bottoms connected and the more tops or bottoms that are joined, the more resilient the trend line is.
In using this strategy, when the price approaches your trend line, the price may either bounce off the trend line continuing with the trend or the price could breakout through the trend line and cause a reversal. Therefore you can open a pending order just above or below your trend line in case of a break out.
- Channels
Another way of helping you to spot a breakout is by drawing trend channels. Drawing trend channels is done by clicking the equidistant channel button on the mt4 platform them clicking the start and the end of the channel on the chart.
The channels are helps the trader to spot breakouts on either direction of the trend. Therefore you can do hedging where you can trade using pending order or you wait for the price to reach one of the channel lines and look at the indicators to help you make your decision.
- Triangles
Also you can spot breakout by identifying triangles which are formed when the market price starts off in a high volatility and then consolidates over time into a tight range. As a trader you should target when the market consolidates so that you can capture a move when a breakout occurs.
There are three types of triangles which are, descending triangle, symmetrical triangle and ascending triangle.
When the ascending triangles are formed one should anticipate for a breakout on the upside.
With the descending triangles breakout occur on the downside.
While with the symmetrical triangles breakouts can either be to the upside or the downside. So with this you may hedge if your broker allows you to do hedging.
How to measure the strength of a breakout
Breakouts’ strength is necessary in determining whether to open a position or not. If you open an order blindly because a breakout has occurred your probability of making profit is 50%.
The strength of a breakout can be determined by using indicators or by learning the forces behind the breakout. If the cause of a certain price movement is external factors (i.e. not due to traders), for example removal of a cap of a certain currency pair, then the breakout may be stronger with minimal chances of reversal.in such a case it is advisable to open a long term position.
However, if the breakout is caused by news then the prices may reverse very soon after breakouts. Actually reversals during news releases takes only a matter of seconds. In these scenarios you should use stop losses and take profits. But there are some major news that points to the start of a trend.
Also trader may open the too many same positions at the same place thus causing some breakouts due to liquidity in the market. Such breakouts happen but are very short leaved.
In using indicators there are various indicators like the Moving Average Convergence/Divergence (MACD) and the Relative Strength Index (RSI).
The MACD can be used by looking at it as a histogram. Then this histogram shows the difference between the slow and fast MACD line. As the histogram gets bigger, the momentum gets stronger. Otherwise when the histogram gets smaller, the momentum gets weaker. Therefore since the MACD shows us momentum, momentum would increase as the market makes a trend. If the MACD begins to decrease, this becomes a clear sign that the current trend could be nearing its end hence you should be prepared for a price reversal.
The Relative Strength Index if used is mostly useful during reversal breakouts confirmation. This indicator shows the changes between higher and lower closing prices in a given time frame.