15.2 Why Trade Breakouts?

Why Trade Breakouts? - Text Version

In the previous lesson, we explained that breakouts happen when the price is contained within a price range and then leaves the range with a strong directional movement. In this lesson, we are going to use real historical price data to show why there is good reason for traders to pay attention to breakouts and use them as tools to help find profit in the Forex market.

The first thing to understand about breakouts is that in every breakout, the price is moving to trade at either higher or lower prices than have happened for some time. For example, a breakout above a 50-day high price means that the price is trading at a higher level than it has done at any time over the past 50 days. Therefore, to measure the effectiveness of trading breakouts, we can analyze what has happened in recent years following days when the price of a major currency makes a new long-term high or low price.

Let’s perform a back test on the six most heavily traded Forex currency pairs by volume: each of the Euro, Yen, Pound, and New Zealand, Australian, and Canadian Dollars against the U.S. Dollar. Together, these account for approximately two-thirds of all the Forex traded in the world today. Using historical price data from 2001 to 2019, which is a long period of time and includes over four thousand data points, we examined what happened over the next trading day after the price closed at a new 50-day high or low. Did the price tend to continue in the direction of the breakout, or not – and by how much?

The results, all normalized by volatility using the 15-day average true range indicator, make interesting reading. The first result we checked was whether the price closed either up or down at the end of the next day. The results show an almost exact fifty-fifty split of up and down closes, so it seems there was no edge in entering a trade and exiting one day later.

Next, let’s look at how often the price went further in the direction of the breakout than against it over the next day’s price movement. In just under 51% of cases, the breakout direction won. Finally, what about the ratio of the next day’s price movement? Here is the statistic that really counts: adding up the total movement of all these breakout days, the price went in the direction of the breakout by approximately 9% more pips than it went against it. If you compare this to a back test based upon whether the price is just up or down over the same fifty days, the edge is far stronger. This is solid evidence in favor of trading breakouts.

Finally, what if we measure the edge from the breakout to the final closing price over not only the next day but over each of the following ten days? What we see here, is that the positive edge for traders in trading with these breakouts grew a little more over every extra day that the trade was allowed to run, up to a total of eight days following the breakout.

So, what does all this mean? It means that if you are trading 50-day breakouts, you can expect that on average, the price will go in your favor the next day by more than it will go against you – this is the statistical edge in your favor. Another factor in favor of breakout trading is that it is easy and takes little time – it can be a true “set and forget” trading strategy.

In this lesson, we explained why it can be a good idea for traders to trade breakouts. In the next lesson, we will explain the common methods that are used by traders to trade breakouts.