How to Use Breakout Strategy in Forex Trading

Breakout strategy is a highly valuable strategy in terms of the ways it can allow traders to view the market and to spot new trends as they are starting to emerge. While there are many approaches that encourage trade execution in response to current price action, breakout trading promotes market entry through anticipating a forthcoming move.

The strategy works well for all timeframes, intraday, daily or weekly. It can also prove to be a good trading strategy for all trading styles. In this article, we will talk about breakout trading and focus on some common breakout strategies.

What Is Breakout in Forex

A breakout is a sudden sharp movement in the price of an asset, which moves away from the established support and resistance areas. A breakout usually indicates a considerable change in supply and demand for a tradable instrument and also that a new trend is probably beginning. A rise in price indicates a bullish breakout trend, whereas a decrease in price indicates a bearish market. There are three key elements in a breakout:

1. Market participation

A spike in volume is a common characteristic of a breakout. As the price of a security makes an exit from normal constraints, the debate over its value heats up. In turn, market participants are enticed to open various long and short positions in an attempt to profit from the perceived opportunity.

2. Volatility

The result of increased market participation is heightened volatility. Heavy buying and selling promotes unstable market conditions, thereby creating pricing fluctuations of greater magnitudes. As volatility increases, the chance of a strong trend developing becomes more probable.

3. Directional move in price

The product of increased market participation and heightened volatility is a pronounced, directional move of price itself. This is the defining characteristic of a breakout; without a definitive move in price, a breakout does not exist.

Types of Breakouts

Breakout trading is used by active investors to take a position within a trend's early stages. Generally speaking, this strategy can be the starting point for major price moves, expansions in volatility and, when managed properly, can offer limited downside risk. 

There are two breakout patterns in forex trading: bearish breakout and bullish breakout. Bullish breakout means the price has started to move upwards following a period of mostly sideways or bearish movement and is expected to continue upwards significantly. Conversely, bearish breakout means the price has started to move downwards following a period of mostly sideways or bullish movement and is expected to continue downwards significantly.

Breakouts can be categorised further into continuous, reversal or false breakouts:

Continuation Breakouts: If traders decide that the trend is moving in the right direction, a continuation breakout could occur.

Reversal Breakouts: Reversal breakouts start off the same way as continuation breakouts in the fact that after a long trend, there tends to be a pause or consolidation. The only difference is that after this consolidation, forex traders decide that the trend is exhausted and push the price in the opposite or “reverse” direction.

False Breakouts: False breakouts occur when the price breaks past a certain level but don’t continue to accelerate in that direction, only to return to the established areas.

Steps to Use Breakout Strategy in Forex Trading

Here are the steps to follow when trading breakouts:

1. Identify Support and resistance

Support and resistance levels develop over time as price "tests" key areas before returning to the control. When established, they are viewed as price constraints, effectively containing the market. Upon price extending past these levels, a breakout may ensue.

Support and resistance can be viewed from the perspective of technical analysis or traditional market fundamentals. Fibonacci retracements, moving averages, pivot points and Bollinger Bands are examples of technically derived support and resistance.

2. Place order and stop loss

Never get into a trade without using a stop loss. No matter how good it looks. The reality of trading is that you will need to take losses.

3. Wait for a break

Wait patiently for the price to make its move. To be sure the breakout will hold, on the day the price trades outside its support or resistance level, wait until near the end of the trading day to make your move.

4. Have an exit strategy

Once you determine your entry point, you need to have your exit strategy in place. A good way to determine a reasonable target profit is to analyze the previous price movements of the asset. Your exit strategy will largely depend on the specific trading circumstances, trading style, your expectations, and the risk to reward ratio.

Conclusion

There are numerous advantages and disadvantages to implementing a breakout trading strategy. While capitalising upon a strong trend may be lucrative, achieving consistent profits can prove difficult. False breakouts and missed opportunities make strict adherence to this approach a challenge. While no one strategy can guarantee high profits in every market, learning to understand how to trade Forex breakouts is a great skill to have.