Breakout trading is a strategy popular in online forex trading and is one of the most effective uses of technical analysis as applied to forex trading. The strategy consists of evaluating and taking a position in an exchange rate at the early stages of the development of a trend.
Breakouts represent the beginning of major and minor moves in an exchange rate, and when used appropriately, can considerably limit a Trader’s downside risk. In addition, breakouts can signal increases in volatility and an awareness of breakouts can often give traders an edge in their forex trading.
Definition of a Breakout
A breakout in an exchange rate can be defined as an exchange rate movement through established support or resistance levels. The movement generally comes with an increase in both volume and volatility and typically takes the exchange rate to a different trading range or furthers a trend.
While the word “breakout” can refer to either an upside or downside break, it is more commonly used to refer to an upside move in the rate. The word “breakdown” is often used when the exchange rate declines and breaks downside support, although the phrase “breakout to the downside” is also commonly used in that situation.
Once resistance is penetrated on the upside, or support on the downside, new levels are established when the exchange rate reacts with a pullback. Furthermore, many traders confirm a breakout using other technical analysis tools, such as moving average crossovers, trading volume, trend lines and other technical indicators.
How to Identify a Breakout
Breakouts can occur in any kind of market environment, and can be triggered by fundamental forces, such as an important economic data release or event. Nevertheless, from a purely technical point of view, the most powerful breakouts come as a result of moves above or below established channels and price patterns.
Patterns which show the most well defined breakouts include: head and shoulder patterns, double tops and bottoms, wedges, flags, pennants, rectangles and triangle formations. Perhaps the most common breakout identified by traders comes from an established upward or downward channel.
Trading a Breakout
The most important element to breakout trading consists in having well defined levels of support and resistance. The frequency of trading in these areas solidifies the support and resistance levels, and will make the breakout that much stronger when the exchange rate moves beyond the established level.
Typically, a forex Trader will establish a long position after the exchange rate breaks out above the major resistance level. Conversely, the Trader will short the rate once the pair drops below the major support level.
Trading breakouts can be tricky, especially if the exchange rate trades briefly above resistance or below support and then continues trading inside the established range. For this reason, many Traders look for confirmation of the breakout move.
One way to confirm a breakout is by gauging the trading volume accompanying the move. If the exchange rate movement was accompanied by high volume, this would serve as confirmation of a breakout. Once the rate has moved into the new level, it must remain above or below that level to further confirm the breakout.