A breakout is a price movement in a different direction from the previous price activity in the forex and crypto markets. It can be a change from a downtrend to an uptrend or from an uptrend to a downtrend.
It can also be a price movement through a well-established support or resistance level. When the price moves past an established support and resistance level, it changes the pattern while still maintaining the trend direction.
For experienced financial market traders, breakouts are also described as the breakout from a point of Agreement (POA), which is when there is a momentary balance in forces on a commodity price.
Looking at the screenshot above, you can see that the market reached a certain point where it started to rise to new highs compared to previous highs. So at this point, we can say that there was a breakout.
The first thing in trading breakouts is to determine whether a breakout is genuine or fake. This can be done by determining the volatility of the market.
How to measure market volatility
Volatility is the measurement of price deviations. Large price movements indicate high volatility, while smaller price movements show low volatility. For traders, these price movements are what bring profits. Therefore the higher the market is volatile, the higher the chances of making profits. But one should be careful since this high volatility also possesses the danger of trends changing, and if they do, they change hugely, resulting in huge losses. This is referred to as price reversals.
Due to the risk of reversals, you should know how to manage risks. This can be done by using stop loss and take profits levels. The stop losses will minimize your losses in case of the reversal, while the take profit will ensure you pocket the cash you had targeted and are out of the market. You may also opt to use trailing stops.
Volatility can be measured by looking at a range of price movements, which is the difference between the high and low prices on any given day. Huge ranges indicate high volatility, and small ranges indicate low volatility.
The range= high – low (The highest prices in the duration being considered minus the lowest prices in the same period)
However, using the daily range is an inadequate measure of volatility given the limit moves and the daily range gaps that are indicated. Due to this, a trader can use some of the indicators available.
The best and most commonly used is the Average True Range indicator that works on obtaining the true range, which is the largest value found by solving the following three equations:
- TR = H – C.1
- TR = H – L
- TR = C.1 – L
Where: L represents today’s low, TR represents the true range, H represents today’s high, and C.1 represents yesterday’s close
The indicator then calculates the average true range (ATR), an exponential moving average of the true range.
Four main types of breakouts
Besides breakouts being either bullish breakouts (upwards) or bearish breakouts (downwards), they are categorized into four categories as follows:
- Legitimate Breakouts
In this case, the price rises or falls instantaneously without retracing for quite a period. However, it might pull back for a few bars, after which it continues moving up and away until the trend ends. This is usually good news for every trend trader.
2. Breakouts with Retrace
In this case, the price breaks out slickly, just as in the legitimate breakout. However, the price slides back to the breakout area somehow. As a trader, if this does happen, give it time to see if it repeats 2 to 3 times, and then you can be assured of opening a trade. However, use risk management strategies to shield yourself from the risk of the trend changing.
3. Fizzle-out breakouts
Price breaks out and then stalls. It’s just there going up and down with no large movements from the specific positions.
4. Fakeout breakouts
In this case, the price breaks out to new highs or lows and instantly reverses. Therefore if you had entered a long-term trend without stop losses, take profit or trailing stops, you are 99% likely to get losses.
Three methods of trading breakouts
1. Using Trend Lines
They are drawn to help in spotting the possibility of breakouts. They are drawn by clicking the trend line button in the MT4 platforms and then clicking the start to the end of the trend you are considering.
In between the two connected outer top and bottom, there may be other tops and bottoms connected, and the more tops or bottoms that are joined, the more resilient the trend line is.
In using this strategy, when the price approaches your trend line, the price may either bounce off the trend line to continue with the trend or break out through the trend line and cause a reversal. Therefore you can open a pending order just above or below your trend line in case of a breakout.
2. Using Channels
Another way of helping you to spot a breakout is by drawing trend channels. Drawing trend channels is done by clicking the equidistant channel button on the mt4 platform and then clicking the start and the end of the channel on the chart.
The channels help the trader to spot breakouts in either direction of the trend. Therefore, you can hedge by using pending orders or wait for the price to reach one of the channel lines and look at the indicators to help you decide which trade to place.
3. Using Triangles
Also, you can spot breakouts by identifying triangles formed when the market price starts in high volatility and then consolidates over time into a tight range. As a trader, you should target when the market consolidates so that you can capture a move when a breakout occurs.
There are three types of triangles which are, descending triangle, symmetrical triangle, and ascending triangle.
When the ascending triangles are formed, one should anticipate a breakout on the upside.
With the descending triangles, a breakout occurs on the downside.
While with symmetrical triangles, breakouts can either be to the upside or the downside. So with this, you may hedge if your broker allows you to do hedging.
Measuring the strength of a breakout
Breakouts’ strength is necessary for determining whether to open a position or not. If you open an order blindly because a breakout has occurred, your probability of making a profit is 50%.
The strength of a breakout can be determined by using indicators or by learning the forces behind the breakout.
If the cause of a particular price movement is external factors (i.e., not due to traders), for example, removing a cap for a particular currency pair, then the breakout may be stronger with minimal chances of reversal. In such a case, it is advisable to open a long-term position.
However, if the breakout is caused by news, the prices may reverse very soon after breakouts. Reversals during news releases take only a matter of seconds. In these scenarios, you should use stop losses and take profits. But there is some major news that points to the start of a trend.
Also, traders may open too many similar positions simultaneously, causing some breakouts due to liquidity changes in the market. Such breakouts happen but are very short-lived.
Examples of the indicators used to measure the strength of breakouts include the Moving Average Convergence/Divergence (MACD) and the Relative Strength Index (RSI).
The MACD can be used by looking at it as a histogram. Then this histogram shows the difference between the slow and fast MACD lines. As the histogram gets bigger, the momentum gets stronger. Otherwise, when the histogram gets smaller, the momentum gets weaker. Therefore since the MACD shows us momentum, momentum would increase as the market makes a trend. If the MACD begins to decrease, this becomes a clear sign that the current trend could be nearing its end; hence you should be prepared for a price reversal.
The Relative Strength Index, if used, is primarily helpful during reversal breakout confirmation. This indicator shows the changes between higher and lower closing prices in a given time frame.