How to Trade Breakouts in Forex

Breakout

It is little wonder that Forex trading has become one of the most popular pastimes for anyone who is looking to make extra money.  Trading in Forex is becoming increasingly popular, and the number of software packages, training manuals, video courses and trading systems that can be used to help is rising all the time.  It can be completely overwhelming with all this information available.  You may have noticed this if you are on any mailing lists.  You get a new Forex sale offer in your email box just about every day, don’t you?

If you are new to Forex and are looking for the best information available then you should be aware that there are many different factors involved in successful trading. This business is certainly not an easy business and do not listen to anyone who says that it is.  It takes time to learn and to master but if you are willing to take the necessary time to study then it can be a profitable business for you.

We are going to study here one of the best ways to making money trading.  This strategy that I want to discuss with you here is called ‘breakout trading‘ and is used by some of best traders on the planet.  Some big banks use this strategy as well as private fund traders.  Before diving into the strategy we should first cover the basics and have a quick look at what Forex is.  Let’s see why Forex is a great way of making money.

Basics Of Forex Quickly Mentioned

If you’ve been in the business for a while then you might want to just skip this section as it’s pretty much just info for newbies.  Forex involves the buying and selling of foreign currencies; traders take advantage of fluctuating currency values of various world currencies.  In Forex it is possible to both ‘buy low, sell high’ as well as ‘selling high and buying low’ which is confusing at first but is quite simple.

By using a broker who will buy and sell for them, traders can utilize software trading platforms that are provided by the broker.  The value of a country’s currency is meaningless in and of itself.  A currency’s value must be compared to the value of another country’s currency in order to determine its value-relative-to-the-other-currency-pair.  After all, the value always relates to the other currency it is compared to.

For example, if we look at the most popular currency pairing, the Euro/United States Dollar, we will be able to compare the amount of dollars it will take to equal 1 EURO.  That is, if you have 100 euros and you come to the United States on travel and you want to exchange your 100 euros  for US dollars, you will want to know how many dollars you can get.  The way you will know will be based on the current exchange rate.  At present, the euro is worth more than the US dollar so you would receive more than 100 dollars in exchange for your 100 euros.

When these values of the currencies change, there is money that can be made.  Forex traders try to guess where the value of each currency will go relative to the value of another.  If they guess correctly then they are in a position to make money.  Traders use software and analytical models to help guess correctly about the price direction over a given period of time.

Global Currency Pairs

Forex trading takes place using certain currency pairs: there are four main pairs that make up the majority of trades on the Forex market, and they are as follows:

British Pound Sterling and US Dollar (GPB/USD)

Euro and US Dollar (EUR/USD)

US Dollar and Japanese Yen (USD/JPY)

US Dollar and Swiss Franc (USD/CHF)

These are the most powerful currencies in the world, and they are influenced by many factors, both domestically and internationally. Many financial institutions and world governments issue regular reports on the state of the economy which take the form of news events.  These news releases are used by Forex traders in order to determine how a market will react.

For example, if the United States  announces that unemployment is worse than expected during ‘Non-Farm Payroll’ then the value of the dollar in relation to other world currencies is likely to fall. If there is an announcement of an improving economic situation, that currency will often increase in value. This may be a simplified explanation, but it does give an idea of how global currency value fluctuations happen.

Making Money With Forex Trading Basics – What are Breakouts?

One of the key skills in successful Forex trading is the ability to understand and predict how the financial markets will behave. World economies are influenced by a variety of factors – political, social and economic news and events all affect the way currency prices move.   International trade has a major effect on the way a currency can rise and fall in value. With the right knowledge, experience and training it is possible to make serious money as a trader.  But do not be deceived or led astray, it is not easy to make money as a Forex trader.  There are countless marketers online who will do their best to convince you otherwise.  Success in trading comes down to patience and calm execution of the basics.  It will take training and practice, often for years, in order to really get things right.

What are breakouts, and how can they be an advantage to you as a forex trader?  Put simply, currency fluctuations tend to take place within certain price ranges.  Price will often move up in down between a small range (often less than 100 pips) and then after some point will have a tendency to break out in one direction or the other.  Those occasions when price breaks free from this range are known as breakouts.

AudJpy currency breakout

Trading Breakouts Effectively

Trading breakouts can be extremely profitable for a Forex trader.  The trick, of course, is anticipating the breakout and getting the correct direction of the breakout.  Now, the simple fact is that all markets experience breakouts, but you need to make sure you are in the right market and ready to jump in when a  breakout occurs, in order to take advantage of the situation.  It is also very important to know that breakouts can also be precipitated by false-breakouts and these can cause trouble for traders.

AudJpy currency false breakout

Dealing With False Breakouts

False breakouts can make the overall idea of trading breakouts particularly frustrating.  Sometimes when price is caught within a range there will be a temporary break of the range.  This range break will often cause many traders to jump on the direction of this temporary break only to have the price shoot back down into the range.  It can be difficult to determine the true break of the range but can often be done by looking for the major key levels and trading with effective stop loss levels and solid risk management.  You should always be prepared for the worst case scenario with each trade and keep in mind that a false break can happen at any time.  Anticipating these types of eventualities can help you become a better trader.

Types of Breakouts

It should be stressed that there are two main types of breakouts that affect the financial markets: these are known as continuation breakouts and reversal breakouts. There are differences between the two that need to be understood if you are to take advantage of them and profit.

Continuation breakouts occur when there is a significant uptrend or downtrend in the market activity, followed by a retracement in the opposite direction (or consolidation) and then a resumption of trading in the original direction. This is when you should take advantage of the trend resumption and go with the flow.

AudJpy currency continuation breakouts

Reversal breakouts show the same signs – a brief pause in trading and a downtrend – but following this the market begins to move in the opposite direction. Knowing when to wait, and when to follow the trend, is part and parcel of sensible and profitable Forex trading.

AudJpy currency reversal breakouts

Although the above are the main forms of trading breakouts it is easy to be fooled by what are known as false breakouts; these occur when a brief spike in trading is interpreted wrongly as a genuine breakout, and certain traders jump onto the bandwagon and are misled. This is why it is important to watch the market carefully before deciding to jump onto a breakout; wait until the consolidation period is over, and take your time to make sure you have the situation correctly analyzed before you risk your funds.

Ideas For Trading Breakouts

There are several possible approaches to trading breakouts effectively.  Each strategy will take a good amount of time to master, but simplicity is often an overlooked key when it comes to breakout trading.

The first idea I have for you here is to set higher take profit levels if the support/resistance you are looking to breakout is near or at the last day/week/month’s support/resistance level.

That is to say if you want to BUY at 1.2200, which is your resistance level calculated by some indicator or your ‘super magic formula‘, and you see that the last months high is only 20 pips away, for example at 1.2220, it is more likely that the price will go up more than usual if it break of that monthly resistance line.  In other words, breaking a major price level can often times send price shooting in one director or another.  BUT BE CAUTIOUS always when trading around areas of major support and resistance or otherwise KEY PRICE LEVELS.  These areas can cause reversals quite easily and make it tough to nail the breakouts.

AudJpy price break last monthly level - monthly breakout

Observe And Trade The False Breakouts

Another idea is to check for false breakouts. Now this does not work 100% of a time, but one trader thought me this technique which sounds pretty cool.

When a price breaks a support/resistance line you wait for it to go a little bit further (say 20 pips), then wait for the price to come back and touch the line it just broke (called “testing the breakout level”) and only then you can place a trade expecting for the price to resume and go into that direction of the breakout.  It is best to use regular pending orders here or hidden pending orders, which can be a very effective strategy to mask entry points from your broker if you have any troubles there normally.

AudJpy currency breakout retest and continue

Measure Your Risk/Rewards Properly

Another advice on stop loss and take profit size is to use at least 1:2 risk ratio. That is if the breakout range is 50 pips, you want to have stop loss of 50 pips and 2x bigger take profit.  This can be a very effectively strategy for overall profit because you can effectively lose twice as many trades as you win and still be in profit.  Some of the best trading systems can employ this type of risk and reward.

Trade Both Directions Of The Break

One idea to trade in both directions of a potential price breakout. As you can imagine, when trading a breakout, price can often go in either direction just as easily.  If you have identified a narrow price range than you might set yourself up for trades in opposite directions on the outer edges of the range.  This can be very effective of a strategy when used properly.

It is obvious that when a breakout system works in a trend, it will fail in a range market. When price starts to bounce off and move in a channel there will be a lot of false breakouts and you will experience losses.

The idea here is to trade both styles, “the trend style” and “the range style”. As always, you would need to have very good money management and stop loss/take profit ratios to do well at this, but these kinds of systems involve BUYing and SELLing on a resistance level breakout. So if price goes up (we are in a trend) you gain profit from a BUY trade, but you may have a loss from the SELL trade. Overall though, the net result is a GAIN. Now if price reverses and goes down (we are in range market) we profit from the SELL trade, but lose on the BUY trade. But again, the net result is still a GAIN. This is something that might work for you in both trending and ranging markets.

A trader friend of mine began testing this idea on what he called the ‘Asian Breakout’ method.  Basically he learned that price often consolidates leading up to the European market open.  It is possible to place opposite orders on the edges of this price consolidation and then to take the trade in whichever direction the price breaks out in.

Conclusion

As you can see, there can be a dozen ways to trade breakouts.  It is a good idea to learn breakout trading and you might find for yourself that it is an ideal method for yourself.  Successful Forex trading and taking advantage of breakouts is all about learning the market and its trends and taking advantage of certain instances in which money may be made.  Patience is a skill that is essential in successful Forex trading, and you have to be prepared to lose money as well as to earn it. Some trades will not go your way, but if you follow the basic rules and learn to interpret trends you could find it to be a profitable and enjoyable business.

About the author

Rimantas Petrauskas

First I am a father, a husband and then the author of the book “How to Start Your Own Forex Signals Service”. I am also a Forex trader, a programmer, an entrepreneur, and the founder of ea-coder.com Forex blog. I have created two of the most popular trade copiers and other trading tools for MT4 that are already used world wide by hundreds of currency traders.

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Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.
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