Forex 103Lesson 5

Breakout Trading

Breakouts are a common phenomenon in the forex markets and occur across different chart intervals. It is therefore no surprise

that break out trading strategies have become one of the most popular ways of trading forex, besides other strategies such as

trend following methods.

In order to trade break outs successfully, traders need to first

understand what causes the break outs, how to identify the break

outs and finally learn the various ways traders can trade forex break outs. This article gives an in-depth overview about forex

break outs and also presents several different forex break out trading strategies.

A break out occurs when prices trade within a tight range. This is referred to a consolidation phase or more commonly sideways price action. Consolidation phases occur either

before a big move or right after a big move. The

consolidation phases are where prices take a pause before resuming the trend.

Taking advantage of this consolidation phase or break out trading can be a profitable trading strategy. The forex

break out trading method involves a bit of subjectivity followed by a purely mechanical approach. Trading break

outs can be done either with pure price action or with the help of oscillators.

Types of Breakout Strategies

Forex break out trading strategies can be classified into the following main types:

Range break out method

Session break out method

Trend line break out method

Channel break out method

Let’s take a closer look at each of these various break out trading

strategies that can be applied to any chart time frame.

Range Breakout

To trade the range break out method, the first step is in identifying a tight range

determined by the high and low. The easiest way to spot ranging price action is to look

for this consolidation right after a previous big move.

The next chart is a EURUSD H4 chart, where the range was specified. We plot the range

high/low after a downtrend was established and instead of price dropping further, it

begins to move in a flat or sideways direction. If you closely look at the chart, you

will find the points 1, 2, and 3.

Point 1 corresponds to the Range high that was plotted after price started moving flat.

Point 2 corresponds to the Range low that was plotted during the course of the sideways price action

Point 3 corresponds to an adjusted Range low

The chart below is how a Range break out chart set up would look like. Now that we have the range high and

low in place, the next step is to place the trades.

Because price was in a downtrend, we are more inclined to take a short

position. This is done by placing a Sell order at the range low with stops

at the range high. The minimum target is the distance of the range (or

distance between the entry and the stops). Traders can then move their

targets for a 1:2 or 1:3 ratio and trail their stops accordingly.

How do we know if the Range high and low are correct?

To ascertain if the range high and low were plotted correctly, the best way to get confirmation is to look

to the left of the chart and see if there was any price interaction at these levels.

The chart below is nothing but looking back in time with the Range High/Low intact. Notice how price previously formed a minor range and in this

case, the break out happened to the upside? This is confirmation that the

range high/low that was plotted was correct and indeed price would

react one way or another.

Another observation to make from the above chart is that break out can occur in either directions. In the

above chart, notice despite a minor downtrend, price

stalled and reversed to the upside at the range or consolidation zone.

The Range break out method can be used in any market and in any time frame. Only thing to bear in mind is

that range/ consolidation phases mean a pause and a

continuation of the previous trend or a pause and a reversal to the previous trend.

Session Breakout

The session breakout method is very similar to the range break out method. The only

difference is that we look for consolidation price action during a trading session. The most

popular of session break out methods is the Asian break out method.

Because volatility is low during the Asian session, as time progresses and we get nearer to

the London session where volatility picks up, prices often consolidate or range during the

Asian session. This is especially true for currencies such as EURUSD, GBPUSD, EURCAD, USDCAD and other non Asian currencies such as AUD, NZD.

For the session break out method, 15 minute, 30 minute and 1 hour charts are used. Asian

session opens at 00:00 GMT and closes at 09:00GMT. London session starts at 07:00GMT and

ends at 16:00GMT. As you can see the overlap of Asian and London session brings a few hours

of volatility, making the session break out method very ideal to trade during these time

frames.

The chart below is of 30 minutes interval and shows the Asian session and the London session and the overlap periods.

After identifying the Asian session High and Low prices, place two

pending orders (Buy and Sell) +/-5 pips from the range high low. The

target price can be set to 20 pips from entry with the stops at the opposite low. When one order is triggered, cancel the other pending

order as shown in the chart below.

The session break out method does not give a good risk/ reward but

it is the certainty of price moving 20 pips from the range high or low is what makes this method profitable. In the even the ranging

price action continues, cancel both orders and wait for the next

day’s set up. Make note that this method works only during active

London trading session.

Therefore do not attempt to trade this method when the UK is closed for a bank holiday as the volatility can be unpredictable. Also, this method works best when there is no news release

scheduled. For example, Eurozone news events are usually

released in the first two hours of the London session open. So if

there is high impact news scheduled, it is better not to trade this

system before, after or during the news release.

Trend line Breakout

The trend line break out method is based on price action trade set up. Unlike range break out method, trend line

break method is used to trade short term corrections or reversals to the previous trend. To trade the trend

line break out method, the first step of course

involves plotting a trend line on a time frame of your choice.

The chart above shows an up sloping trend line that was drawn by connecting two consecutive lows. This tells us to look for short positions when the trend line is broken. There are two ways to trade the trend line break method.

TL Break Method 1: Sell or Buy on immediate breakout with stops at previous high or low, targeting the middle low and finally the initial low (or highs).

The chart below shows how a sell order was placed after a full candle opened and closed below the trend line with the stops at the recent/previous high and the target 1 at the

middle of the trend line and target 2 near the bottom/initial

end of the trend line.

This method is a bit risky because prices can break a trend line only to reverse and continue the previous trend.

TL Break Method 2: Wait for a retest of retracement and target the

previous move.

In this second method, we wait for a retest of the break out, which

we can see how price rallied back up to test the same price as the initial break out. In this method the targets are well defined.

The purpose of Target 1 is to ensure that if price doesn’t reach

Target 2, the trade can be closed out as it signals a potential

reversal. In the above example, after a retest, price

conveniently managed to hit both the targets, making this a safe

entry.

In this method, there is a risk of missing out on a trade if price

momentum was extreme. In such cases, there are no retracements

and thus the trader misses out on a profitable move. However, trading retest of the trend line break outs is a safer approach.

Channel BreakoutThe Channel break out method is based on the same principles of trend line break out method. The

only difference here is that the channel connects highs and lows and therefore is a better way to trade. The only issue with channel break out method is that it takes a lot more time to find the

right price channel to trade. This method works on any time frames.

To plot the channel, make use of the equidistant channel, connect two consecutive lows or highs

first and then adjust the channel to connect the intermediate high. The chart below shows how

the channel is plotted.

Now that we have the channel in place, the next step is

to wait for the right conditions, which is to wait for a

break out. In an up sloping channel look for break out of

the lower channel line and in a down sloping channel, look for break out of the upper channel line.

In the next chart below we notice how a break out to the downside occurred. We wait for a retest of the break out

price level and take a short position with stops at the previous support/resistance levels formed inside the

channel. For targets, we look to the bounces or support/resistance levels formed during the channel was formed.

Here we see that price managed to reach only Target 1. This is

indicative that we could see a reversal very soon. This gives us

another possible trade and we plot a new channel connecting the consecutive highs and lows to give us a down sloping channel.

Here we notice how the break out to the upside was retested giving us a long opportunity and this time price rallied all the way to reach Target 2 as well.

From the above different types of breakout trading strategies we can observe that it is easy to trade using break outs, regardless of the type of strategy you

make use of. With a good defined risk/reward ratio is

most cases, break outs can become easy to trade with

enough practice and understanding of various aspects such as trend lines, channels, support and resistance