Forex Investment and Currency Trading

After you’ve identified a likely breakout point, you can use a resting stop-loss entry order placed just beyond the breakout level to get into a position when a breakout occurs. To get long for a break to the upside, you would leave a stop-loss entry order to buy at a price just above the upper level of the range or pattern. To get short for a break lower, you would leave a stop-loss entry order to sell at a price must below the lower of the range or pattern.

The appeal of using stop-loss entry orders is that you’re able to trade the breakout without any further action on your part. Breakouts can occur in the blink of an eye. Just when you thought the upper range level was going to hold and prices started to drift off, for example, they’ll come roaring back and blow right through the breakout level.

Price moves like that can leave the most experienced traders caught like deer in the headlights. By the time they react, the break has already seen prices jump well beyond their desired entry level. Worse, by trying to trade at the market in a fast-moving breakout, you may miss your price and have to reenter the trade, by which time prices will have moved even farther in the direction of the break.

When placing a stop-loss entry order to trade a breakout level, be aware of any major data or news events that are coming up. If your stop-loss entry order is triggered as a result of a news event, the execution rate on the order could be subject to slippage, which may wipe out any gains from getting in on the breakout.

Trading the retest of a breakout level

The other way to trade a breakout is after the breakout has occurred. You may not have noticed the significance of a particular technical level, or you may not have left orders in overnight to go with a breakout. You turn on your computer the next morning to discover that prices have jumped higher overnight and feel like you’ve missed the boat. But you may still get a chance to trade the breakout if prices return to retest the breakout level.

A retest refers to a frequent price reaction after breakouts, where prices eventually reverse course and return to the break level and retest it to see if it will hold. In the case of a break to the upside, for example, after the initial wave of buying has run its course, prices may stall and trigger very short-term profit-taking selling. The tendency is for prices to return to the breakout level, which should now act as support and attract buying interest.

You can use these retests to establish a position in the direction of the breakout, in this case getting long on the pullback. When trying to get in on a retest, you may consider allowing for a margin of error in case the exact level is not retested.

You “may” get the chance to buy/sell a retest of a breakout level. The reason is that not every breakout sees prices return to retest the break level. Some retests may retrace only a portion of the breakout move, stopping short of retesting the exact break level, which is typically a good sign that the break is for real and will continue. Other breakouts never look back and just keep going.

But to the extent that it’s a common-enough phenomenon, you still need to be aware of and anticipate that prices may return to the breakout level, and the level holds, it’s a strong sign that the breakout is valid, because market interest is entering there in the direction of the break.

Guarding against false breaks

Breakouts are relatively common events in currency trading, especially from a very short-term perspective. But not every breakout is sustained. When prices break through key support or resistance levels, but then stop and reverse course and ultimately move back through the break level, it’s called a false break.

There’s no way to tell whether any given breakout is going to turn out to be a false break except in hindsight. To protect against false breaks (as well as maintaining trading discipline and sound risk management), you also need to follow up your stop-loss entry with a contingent stop-loss exit order to close out the position if the market reverse course.

Although there’s no surefire way to tell whether a breakout is a false break or a valid one that you should trade, here are a few points to keep in mind:

• Time frame of the breakout level: The shorter time frame you’re looking at, the greater the potential for a false break. The break of a price range on any hourly chart may trigger stop losses only from short-term intraday traders. But the break of a daily price range dating back several weeks is likely to spark greater interest from the market, especially systematic models.
• Significance of the price level: The more important the price level that’s broken, the more likely it is to provoke a market response and to be sustained. A break of a three-month daily trend line is more likely to trigger a market response than the break of recent hourly highs/lows.
• Duration of the break: The longer the breakout level is held, the more likely the breakout is to be valid. Many false breaks are reversed in a matter of minutes. An hourly closing price beyond the break level increases confidence that it’s a valid breakout, and a daily close beyond confirms it.
• Currency pair volatility: Relatively volatile currency pairs, such as GBP/USD and USD/CHF, are more prone to false breaks than others, especially in short-term time frames. Look for confirmation in bigger pairs, like EUR/USD and USD/JPY. If they’re pressing against similar price levels, the less-liquid pairs could be leading the way.
• Fundamental events and news: What’s the fundamental reason for the breakout? Did someone say something? Has a major market expectation been disappointed? Sustained breakouts tend to have a fundamental catalyst behind them – a significant piece of news that has altered the market’s outlook, resulting in the breakout.

Trading breakouts is a relatively aggressive trading strategy and is certainly not without risks. Until you’ve gained some experience in the forex market you’re probably better off focusing only on breaks of levels identified by trend-line analysis in longer time frames, such as daily charts, or breaks of longer-term price levels, like daily or weekly highs/lows. They may not occur as frequently, but they’ll tend to be more reliable.