Breakout trading strategy refers to the strategy of opening long positions after price breaks out of resistance or opening short positions after price breaks out of support level.
A breakout occurs when prices shot or drop out of a defined support/resistance area. Hence, breakout trading strategy refers to the strategy of opening long positions after the price breaks out of a key resistance or opening short positions after the price breaks out of a key support level.
Breakout trading strategy is derived from stock trading where the volume is often followed by a significant breakout which means prices will go in the direction of the breakout. It differs slightly from the concept of a breakout in forex trading which aims to take advantage of the high volatility that coincides with the breakout. However, due to underlying differences between stocks and forex, forex breakout strategy is often considered less reliable. Still, it is a fairly popular strategy that is often employed among retail traders.
Steps to Trade with Breakout Strategy
Here are three steps to apply a breakout strategy:
1. Define a Set of Support/Resistance Area
There are a number of ways to define a set of support/resistance areas apart from drawing manual lines on the chart. It could be done as well by looking for chart patterns, channels, or even Fibonacci. In the picture before, for instance, the breakout was decided after the price shot out of key support that was constructed by drawing a line on a series of higher lows.
2. Find the Entry Point
The best time to enter the market is after a candle closes outside of the defined area. Breakout trading strategy is prone to false breakout that leads to losses; thus to be safe, it is quite important to ensure a candle has closed outside of the area. It does not guarantee success 100%, but it certainly gives your entry additional assurance.
3. Determine the Exit
When you trade within an area, you can simply put a profit target on the last support/resistance. However, you cannot do that when the trade is based on an area's breakout. So, how to determine exit points? As usual, there are many ways to do that depending on your own strategy, although you may be unable to simply use the last support/resistance or Fibonacci levels. What's important here is that if a breakout is genuine, then the possibility for prices to go back to prior levels is quite small; but it is not impossible. Thus, the best decision would be to apply a trailing stop for targets beyond an acknowledged area.
Forex Breakout Strategy with Price Action
In this example, we would use doji candlesticks as the price action indicator. Doji typically indicates that the market is in a consolidation phase where the opening and closing prices are the same or nearly the same. A candlestick with this pattern typically has a very thin or non-existent body.
In order to get more accurate signals, we use "double doji" or two consecutive doji patterns on a chart. When this pattern appears, traders are advised to wait and observe until it becomes clear which direction the price is moving in. This is usually indicated by the third candle after the appearance of the double doji pattern.
The steps for this strategy are as follows:
- Wait for two doji candles to appear.
- Mark the high and low points of the doji candles.
- Wait for the third candle to appear.
- If the third candle approaches the upper wick of the candlestick, enter a buy order and place a stop loss 2-3 pips below the low of the doji candles or 2-3 pips below the third candle.
- If the third candle approaches the lower wick of the candlestick, enter a sell order and place a stop loss 2-3 pips above the high of the doji candles or 2-3 pips above the third candle.
- Set the profit target at the nearest swing high for buy orders and the nearest swing low for sell orders. The target can also be set at three times the risk.
Forex Breakout Strategy with Donchian Channels
This forex strategy is based on a breakout entry and exit at the extreme 20-day. This means that entry and stop and reverse should be at the highest or lowest price level of the 20-day period. Of course, traders must take a long-term position because the minimum time frame used under this rule is daily.
The appearance of the Donchian Channel indicator is similar to Bollinger Bands (BB). However, the calculation is simpler. If the BB reference is standard deviation, the Donchian Channel uses extreme price levels. This indicator consists of three curved lines, each of which is the 20 SMA, the 20-day high, and the 20-day low.
Since 20 candles are accounted in 4 weeks in the daily time frame, this strategy is also called the 4-week rule.
The rule is to enter a breakout at the highest or lowest level. Entry is made on the next bar provided that the current bar's closing price is above or below the highest or lowest price. So:
Enter buy and exit sell (close open sell position) if the price breaks the 20-day high, or enter sell and exit buy (close open buy position) if the price breaks the 20-day low.
This indicator can work well in futures and commodities markets. It is even very relevant to be applied to the forex market, especially for medium and long-term trading using daily time frames.
The "Second Chance" Breakout
If the price breaks above a price pattern, then the second chance provides a buying opportunity. If the price breaks below the price pattern, then the second chance is a selling opportunity.
If you are targeting a second chance, get ready to open a position as soon as the price pullback enters the range of the initial breakout point. As soon as the pullback slows down and the price starts moving in the same direction as the previous breakout, immediately open a position.
When exactly does it mean "start moving in the same direction as the previous breakout"?
The answer can be subjective and depends on what approach or trading strategy you choose to use. For example, the engulfing candlestick pattern can be used as a signal that the pullback has ended and the movement forward in the same direction as the previous breakout has begun.
If the initial breakout was downward, wait until the price pulls back up near the breakout point, then as soon as the price starts to fall again, sell. Place the stop loss a few pips or ticks above the high level of the previous pullback.
The image below describes the ideal application of the strategy:
Risks of Breakout Trading Strategy
It's worth noting that breakouts on currency pair movements are relatively less reliable if compared to breakouts on stock prices. There are at least two risks here:
- False Breakouts
Often, the price breaks out of a certain range only to go back to the previous range after a few pips outside. Some say that these false breakouts occur because of inaccurate support and resistance identification. However, since price moves are often driven by market euphoria that disregarded proper support and resistance, that reason is not always true.
- Insufficient Volatility
The thing is, to break out of its normal range, currency pairs need more volatility too. Insufficient volatility might cause the price to retrace back its moves. Many dreams of encountering surprising news that would send the price to skyrocket or plunge, but such happenings are actually quite rare.
Traders should understand that breakout trading strategy is not a 100% accurate trading plan, and take necessary caution to prevent failings. Also, correct implementation of technical indicators and sufficient practice are more important for successful trading than sticking to a certain strategy ceaselessly.