September 07, 2017
A breakout happens when the price breaks a support and resistance level, Fibonacci level, trendline, etc. This is usually accompanied with a rise in volatility, which means the price start to move really fast just after the breakout happened.
As a trader, you want to catch these breakouts and enter the market just on the breakout, in order to capitalize on the rise in volatility.
Unlike in stock markets, where traders have information about trading volume, forex traders don’t have access to such information. This means that we have to rely on good risk management in order to enter a good breakout trade.
Trading on high volatility can also be risky as the large price movements can trigger your stop-loss in a short period of time.
How to Measure Volatility
As said before, volatility measure the price fluctuation over a certain period of time. Knowing the volatility of a currency pair can be of big help when looking for breakout opportunities.
You can use a few excellent tools to measure the current price volatility, like Bollinger bands and the Average True Range indicator.
Bollinger bands is actually designed to do exactly that. It consists of three lines, one of them is a moving average and the other two are plotted at 2 standard deviations above and below the moving average. When the two lines widen, the volatility is high – and the when the two lines contract, volatility is low. The following chart shows how to use Bollinger bands when measuring volatility.
The Average True Range (ATR) indicator is another useful tool to measure price volatility. An increasing value of the indicator indicates a rising volatility, while a decreasing value indicates a falling volatility. The following chart shows how to use the ATR indicator to measure volatility.
Types of Breakouts
There are two main types of breakouts in the forex market:
- Continuation breakouts
- Reversal breakouts
A continuation breakout is a breakout which continues in the same direction as the main trend. They occur after the price consolidates (range-bound market) after a significant move in price.
A reversal breakout, as the name suggests, reverses the previous trend in the opposite direction. In the beginning, it forms just like a continuation breakout, after the price consolidates after a big push in price.
There are also a third type of breakouts, called “false” breakouts. A false breakout occurs when the price moves outside the consolidation range and closes outside, but doesn’t continue in the direction of the breakout. Instead, the price moves back inside the consolidation range.
How to Trade Breakouts Using Trendlines and Channels
Beside trading breakouts out of consolidation phases, you can also use trendlines and channels to trade breakouts. By now, you already know what trendlines and channels are. When the price makes higher lows or lower highs, you can connect those price swings with a trendline and wait for the price to break out above or below the trendline. The following chart shows how to use trendlines when trading breakouts.
Similar to trendlines, you can also use channels to trade breakouts. When the price bounces off the upper and lower channel trendline, it’s only a matter of time when a breakout will occur. After the price breaks the channel, wait for the candlestick to close and enter a position in the direction of the breakout. The following chart shows how to trade a short position after the price breaks out of a channel.
Measuring the Strength of a Breakout
There are a number of ways to measure the strength of a breakout in order to confirm it. One of the most popular is to use technical indicators like the MACD or RSI.
As you already know, the MACD plots a histogram which is telling a lot about the underlying momentum of the price movement. As the histogram gets bigger, the momentum is getting stronger. And as the histogram gets smaller, the momentum gets weaker. The MACD can be used to spot divergences between the price and the indicator, which tell us about the underlying momentum of the recent price movement.
The RSI plots the changes between the recent gains and losses during a specific period of time, and can also be used to spot divergences just like the MACD indicator.
One of the ways to use MACD and RSI to confirm breakouts is to look for divergences in the price and the indicator, which we discussed earlier. If a bullish divergence forms during a downtrend, it shows the bearish momentum is getting weaker and indicates that a reversal breakout is more likely. Similarly, if a bearish divergence forms during an uptrend, it shows that the bullish momentum is losing steam and that a reversal breakout could be ahead.
Fading breakouts, i.e. trading against the direction of the breakout is a great short-term strategy. Many breakouts will initially fail and create false signals, which means the price will move back to its prior price level in the end. This is how the big players with large trading accounts trade. They know that smaller retail traders will jump on a trade as soon as a breakout happens. The big players will place opposite orders than retail traders, as any sell position needs buyers on the opposite site, and any buy position needs sellers.
This is how false signals form which in the end move back to their prior price level. And as many breakouts initially fail, you can benefit from it on opening trades against the breakout i.e. fading the breakout. But remember to use stop-loss orders all the time, in case the breakout shows to be a real one.
How to Detect Fakeouts?
When the price breaks a support or resistance level, trendline or channel, traders expect that enough momentum has built up and the price will continue in the direction of the breakout. However, this is not always the case.
If the support or resistance level has a high importance, it is more likely that the price will try to break it but ultimately fail, creating a fakeout, i.e. false breakout.
You should wait for the second candlestick to close also in the direction of the breakout, or wait for the broken resistance to act as support (and vice-versa) to confirm that a breakout isn’t a fakeout. As discussed earlier, using divergences and measuring the strength of the momentum can also help in confirming real breakouts.
Is it Possible to Trade Fakeouts?
Yes! Fading breakouts is possible and can be a great short-term strategy. However, you need to be careful that the fakeout is not a real breakout, otherwise your stop-loss will be hit pretty quick. In order to spot fakeouts and trade them, you need to look how the price performs after the break. Let’s look at the next chart.
Look at all these false breakouts. They all have one thing in common, the long wicks show that the momentum wasn’t strong enough to push the price in the direction of the breakout. Furthermore, the price-action before the fakeout looks bearish, without enough buyers to catapult the price highers. You could trade all these fakeouts, with tight stop-losses just above the wicks. The real breakout shows a big green candlestick breaking the trendline, which is a sign of a real breakout.