What is a breakout?
In the simplest of terms, breakouts are price spurts above or below a certain price level on the price charts.
See breakout as the price breaking free from something that was stopping it.
Whenever you see a breakout, you will notice that the price was moving in the range prior to its breakout.
It will move between an upper resistance level and a lower support level. These levels were holding the price from breaching the levels and hence it stays within it.
It is often said that the more time the price spends inside a range, the bigger and better the breakout is.
After price ranges between two levels, it can’t just stay in it forever, we then see a breakout in either direction.
Once a breakout plays out, the price trends in the direction of the breakout and it continues unless something happens fundamentally or technically that changes its course.
How are breakouts formed?
The forex market comprises two types of participants, the institutional players, and the retail players.
The price movements that we see are largely caused by the activities of the institutional players. It is them that move the markets.
Now, these big-money players, or whales as we like to call them, do not just come into the market, place their trades for millions or billions of dollars, day trade or swing trade it, and leave.
They instead build their positions over a period of time and they try to keep their average price as low or as high as possible. This is what makes the price move in phases.
The phases are mainly the accumulation phase and distribution phase.
In the accumulation phase, these whales build their position over time. They have a large capital to put in hence they need that much liquidity in the market.
This accumulation phase is the ranging phase that we see on price charts.
These whales do not just build their position in any given currency pair just based on gut feeling.
They have access to sophisticated information and tools and they have a bias for the asset.
Once they have built their position, they wait for the plan to play out. This could either be a news release or some event that majorly influences the price.
Other market participants will react to this and take positions, but the whales have already built their mega-million or billion dollars position and they will see their position raking in the profits.
This is what separates retail players and the institutional players or the whales.
I will discuss the best ways to trade breakouts further in the blog post, so do not skip any part.
Types of breakouts
Breakouts are not uniform, they have different types. These types are based on the direction of the breakouts as well as their success.
1. Continuation breakouts
It is said that price trends around 30% of the time. Hence before going into an accumulation or range phase, the price will have been moving in some trend beforehand.
A continuation breakout is when the price breaks out in the same direction as it was before the consolidation.
If the price was already in an uptrend and it entered the accumulation phase, the breakout would be a continuation breakout only if the price broke out on the upside.
If the price was in a downtrend, then the breakout should be on the downside for it to be a continuation breakout.
2. Reversal breakouts
If the price breaks out in the opposite direction of the prevailing trend, then it will be called a reversal breakout.
A price already in a downtrend, goes into a consolidation, and the breakout is on the upside, then this is a reversal breakout.
If the price is already in an uptrend, and the breakout taking place on the downtrend, is a reversal breakout.
These reversal breakouts give a clear indication that the market sentiment has completely changed and that the participants have switched hands.
3. Fake breakouts
You will have seen that price moves in a range for some time, a candlestick will be formed that looks like the price has broken out of the range, but the price falls back into the range.
This is what is known as a fake breakout, even known as a fakeout.
Now, these fakeouts can take place on either side, doesn’t matter if the price broke out of the range from the upside or from the downside.
Many retail traders label this as market manipulation but in reality, it is just a liquidity grab by institutional players towards building their position.
The right way to trade breakouts
The most common method that retail players use to trade breakouts is to take an entry from the candlestick that breaks out and closes above or below the range.
This may work sometimes and you might ride the trend, or you may fall for a false breakout or fakeout.
We already know that the whales move the markets and we just have to identify their actions and move along with them.
Whenever you see price facing difficulties in breaking a price level, don’t just enter on the breakout candle.
If the breakout candlestick is a big one and an impulsive one then any entries that you take will mess up your RRR as your stop loss will be placed very far away from your entry.
You should always think in terms of RRR. If you have a decent RRR with a healthy hit ratio then you will end up profitable at the end, if not then you will find difficult to stay on the green side of you PnL.
When I trade, I always look for a RRR of at least 1.5 to 1.7. Anything above that is always welcome but anything below that is a big no.
In such cases where the breakout candlestick to too wide, you should wait for the price to consolidate in a range or form any kind of pattern.
Once it breaks out from this newly formed structure you can look to take an entry. By doing this you can ensure that you are not chasing strong moves but are only entering when the conditions are in your favor.
You can also have a look at what happened prior to that breakout.
If the price just bounced from the opposite side of the range and broke out then maybe avoid it.
A better method would be to look for some kind of momentum shift or buildup before the breakouts
These buildups are not going to give you an indication of an imminent breakout and neither should you expect any such things from it.
A buildup will simply help you in improving your RRR. Your entries will be the same but the level at which you place the stop loss will become better.
By this, you will ensure that you are not just a mere reactor to price action but rather have substantial information to support your breakout trade.
Trade plan for breakout trades
1. How to take entries?
Like we mentioned earlier, you shouldn’t just react to a breakout and take an impulsive entry at breakout candles but rather look for further confirmations.
a. Taking entries in continuation breakouts
While trading continuation breakouts look for chart patterns like triangles, pennants, wedges, and rectangles.
These patterns are very powerful and provide loads of information about the market conditions.
Take entries in direction of the breakout of price, and this breakout should be in the direction of the prevailing trend.
b. Taking entries in reversal breakouts
If you spot a reversal breakout then look for patterns like head and shoulders, double tops, and triple tops.
Again, take entries in direction of the price breakout and this breakout should be in the opposite direction to the prevailing trend.
c. How to avoid fake breakouts?
Now, you will come across fake breakouts and the best way to avoid them is to look for a price buildup i.e. look for higher or lower highs and lows.
You can also gain additional confirmation by looking at the volume. If the volume has increased with the breakout then it is a good sign.
One more method to avoid getting caught in a fake breakout is by looking for a pattern or structure on the highest of timeframes.
Wait for a candlestick to close outside the structure and then only take an entry.
If this condition is not met then avoid this breakout as it has a higher probability of being a fake breakout.
d. Taking entries at break of previous swing high or low
One more method for taking entries in breakouts is to enter once the previous swing high or previous swing low is breached.
Whenever price trends, it creates swings. Price will not always create a pattern or a range in case of breakouts.
The price might quickly change momentum and go on to break a swing low to the downside and a swing high to the upside.
If the price is in an uptrend, then a downtrend is confirmed when the price breaks below the previous swing low.
If it is a downtrend, then the uptrend is confirmed once the price breaks the previous swing high to the upside.
Breakout trading is valid in such scenarios too and entries should be taken only after a valid price breakout has taken place.
2. Where to place a stop loss?
Once you take an entry, you should first decide where your stop loss will be placed at.
Now for placing stop losses, you can have multiple plans.
Traders usually place their stop loss on the opposite side of the range. They might also keep a buffer of some pips.
If the breakout is bullish, then stop loss is placed just below the support. If it is bearish, stop loss is placed just above the resistance.
You can also place your stop loss at the previous swing high or swing low.
Some traders determine their stop loss according to ATR values.
You should test all these methods before applying them in live markets. Stop losses are as important as entries, so do not take them lightly.
3. Where should targets be?
As to targets, you can either have fixed targets or have flexible targets.
In fixed targets, you can look to set your take-profit orders according to your risk to reward ratio.
Or you can even target the next support or resistance zones that lie in the path of the price.
If you want to have flexible targets, then you should plot a moving average and exit only when the price closes below or above it.
Both target plans have their own pros and cons. Hence it is important that you test both and decide what works for you best.
Misconceptions in breakout trading
I have heard many traders say that in order for a support or resistance level or a pattern to be considered strong, the price should have touched it like 4 to 5 times.
This is one claim that has no logic behind it. There are times when the price breaks out from a level after 2 touches too.
Another misconception is that there are strong breakouts and weak breakouts. Traders make such claims based on the size of the breakout candlesticks.
I believe that the market is not so certain, it does not follow any such rules. We as traders should not try to believe such things but we should focus on trading what is in front of us and not try to make predictions.
I came across a trader who said that no entries should be taken after a price breakout if there are any support or resistance zones in the price's path.
For instance, if the price has broken above a range and if you have another resistance above it, then according to the trader's rule, no entry should be taken.
What I believe is that and like I have already mentioned is that we as traders should think in terms of RRR.
Even if you see a support or resistance zone in the price's path, do not hesitate to take an entry if you have a good RRR. In order to achieve this you should first know where your stop loss will be at.
Do you trade breakouts?
How has your experience been with regard to breakout trading and what is your plan to trade such price movement? Do let us know.
Share this blog post with every trader you know and let them also boost their profits by taking advantage of price breakouts.
Feel free to hit the comments section for any question or query and we will make sure to get back to it at the earliest.