Trend trading revolves around trading pairs that bounce off support and resistance levels on a chart. But what happens if the price breaks through a support or resistance level? Welcome to the world of breakout trading. Breakout trading is the act of trading a currency pair that is positioning to breakout of an established trend to form a new trend.
Breakout trading is considered to be a more advanced trading strategy because in order to trade you must be a proficient trend trader and have a very comfortable understanding of technical analysis and fundamental analysis. This is why I often do not recommend beginners trading breakouts, there is a lot that can go wrong in a short amount of time. Now that we have stated the risks, lets get into breakout trading.
While breakout trading is predominantly technical analysis based, it is the fundamental data that pushes the currency pair above the support or resistance.
As you can see from the visual above, this is an example of what a breakout trade looks like. At the left of the visual, we see the price action coming into a trading range. Notice the strong support and resistance levels the price action faces before the breakout. Once the price action hit the resistance for a third time, we saw a breakout.
In order to determine whether or not the price will breakout or not, we turn to our indicators. Using MACD and/or stochastics, we are able to determine whether or not the price is looking to reverse or continue.
Using the chart above, it is pretty easy to tell that the price action has broken out towards the downside. However, there is a way to tell whether there is a risk of a breakout or if the price action will simply just bounce off support. That is where the bottom chart comes in. Just to be clear, that bottom chart is a stochastics indicator which is considered to be popular and widely used. Notice where the arrow is pointing to the bottom chart and reads “overbought”. The stochastics indicator was giving us an overbought signal when the price action was at support. This is a great signal that we could see a breakout to the downside because even though the price is at support, the pair is still overbought and provides limited upside potential and a higher probability of a fall.
Remember, this happens at resistance also. If a price action is at resistance level and the stochastics or other similar indicator reads “undervalued”, there is a pretty good chance that we could see a breakout. However, it always helps to have a big event come in your favor. This is where having the knowledge of fundamental analysis comes in. Say you are trading the EUR/GBP and currently the price action is stuck in range but the price is currently at resistance. Next, take a look at your indicators. If at resistance and your indicator is giving you an undervalued signal, this could be a sign of a very high probable trade. Before trading, check to see the underlying fundamentals and whether any reports are coming out soon. If there is a report out from the EU that exceeded estimates or a UK report that came in under expectations, you have a very big chance of a profitable trade.
The bottom line here is that breakout trading can lead to anxiety because trades are usually far and few between. Or if the trade does breakout, there is always a risk of it being a false breakout. Remember this article is not supposed to be your sole education to breakout trading but rather an entry level way for you to be exposed to different types of trading. If you are interested in breakouts, continue your research until you feel that you have a thorough understanding of the concepts, then open a paper account.