15.3 Breakout Trading

How to Trade Breakouts - Text Vversion

In the previous lesson, we explained that long-term directional breakouts in the most traded Forex currency pairs tend to move more in the direction of the breakout over the next day than against it. In this lesson, we are going to discuss how traders typically try to capture this edge on a practical level, using the classic breakout method. With this, we will build a rules based, simple Forex daily breakout strategy.

The classic breakout trading entry method involves identifying the price range you hope for a breakout from, and then placing either a buy stop order just above the high, or a sell stop order just below the low, or possibly both.

For example, if the price were nearing a 50-day high and you wanted to trade the breakout, you would just identify the highest price made in the last fifty days and place your entry order just above it.

The next step is to decide where to place your hard stop loss. You might try to put it just behind a key support or resistance level, or use a consistent method based on the average true range indicator’s current value to ensure you have a volatility-based stop loss, or even a combination of both approaches.

For example, say you are hoping for a breakout above 1.1000. You place a buy stop order at 1.1001. You think there is support below the current price at 1.0950. The 15-day average true range indicator is at 90 pips and you want to use half of that. This would give you a stop loss at 1.0955 but you decide to try to use the support too, so you place it close to 1.0955, just below 1.0950 at 1.0949.

Your final issue in this trade is going to be managing the trade, meaning - where to exit the trade. Many traders use a system where they set a take profit order at a fixed larger multiple of the distance from the entry to the stop loss – for example, if the stop loss is 51 pips, and you are aiming for a reward to risk ratio of 2 to 1, you set a take profit order 102 pips above the entry point. More skilled traders might try to apply discretionary exits based upon a combination of statistical data on historical prices and the price action which happens after the entry takes place. Time-based exits, where open trades are closed after a predetermined amount of time, are also a popular method.

There are many variations in use on these methods, and we are going to talk about them in the next lesson to identify the best breakout strategy. Before we do that, we are going to end this lesson by emphasizing the importance of using a tight, hard stop loss when trading breakouts. This is because although tight stop losses will give you fewer winning trades, they will always give you greater total profitability over time, because the very best trades move right into profit just after entry and keep going up. This is not an easy concept for most people to truly understand, but for most traders, this is the key to achieving profitability in the Forex market. However, beware of using stop losses that are too tight, as you might then go months or years without winning any trades at all! You have to find a balance between your overall profitability and your win percentage.

In this lesson, we explained the common methods used by traders in trading breakouts. In the next lesson, we are going to explore more advanced breakout trading methodologies.