In the forex world, there are various popular and viable trading strategies, which when used diligently can turn out to be some amazing profitable strategies. These strategies can be learned easily and are used by both beginners and professionals in this field. Skilled traders, with the help of such strategies, trading tools, and techniques, are able to sense what is the current market sentiment and behavior. They are then able to quickly react accordingly keeping in mind the current situation in order to make use of these profitable strategies. One of these concepts, that can help you understand when to enter and exit the market is to understand trading Breakouts and Fakeouts.
As the name suggests, a breakout is referred to a situation when the price ‘breaks out’ of some kind of past trend or a trading range. It is also used for situations when the price level, such as Fibonacci levels or support and resistance levels are breached and enters into a new trading range. The idea behind trading breakouts is to enter the market when it breaks out and then manage your trades accordingly until there is no more volatility in the market.
Concept of Volatility
To trade breakouts such that they lead to profitable trades, it is essential for you to keep an eye on the current amount of volatility in the market in which you are about to take a position in. If large price movements take place in the market then this signals the high amount of volatility, whereas little price movements signal low volatility.
It is mostly recommended by professionals and experts of this field to first study the forex market, look for trades and currency pairs that are currently less volatile, and they are ready for breakouts once the price becomes volatile. The key here is to use volatility to your own advantage.
Volatility is used to measure the overall fluctuations in price for a specific selected time period and is used to identify potential breakouts in the trading pattern that can help you land on some great breakout trade opportunities.
To determine a currency pair’s volatility at the current moment here are a few indicators that will guide you tremendously during the identification process.
This is one of the most widely and most common indicators that is used by almost every forex trader. It provides data that is invaluable and can be calculated by taking an average of prices for a specific time period. For example, if 20 SMA is applied to a daily chart it means it will demonstrate the average movement f price for the past 20 days with the help of a single line on the chart. This can be better understood with the help of a graph that is illustrated below.
Other types of moving averages which include weighted average, exponential moving average, and others are a little more sophisticated and are also used for the same purpose.
Bollinger bands have been particularly designed to measure volatility and price fluctuations; hence it is one of the best tools for this purpose. Basically, these bands are two lines that are plotted 2 standard deviations above and below the moving average line for a selected period of time. The line above is basically +2 standard deviations and the line below is -2 standard deviations. When these two lines of standard deviations expand and move away from moving average line then it means volatility is high whereas if these two bands contract and move closer to the moving average line then it means that there is low volatility.
Below is an illustration of a chart for you to better understand the two standard deviation lines.
Average True Range (ATR)
As the name suggests, this indicator is extremely useful as it tells us the average trading range in which you should trade, given the specific period of time that is taken into consideration. If the Average True Range is low and is falling then it signals that the volatility is decreasing and if the Average True Range is increasing and is high then it indicates that the volatility is increasing.
The chart below shows the examples of both high ATR and low ATR by highlighting the two areas.
Breakouts can be traded with the help and combination of other forex toolbox techniques. These opportunities for potential trades are fairly easy to detect once you get accustomed to the technique used and are able to identify the signs of breakouts.
Trading Breakouts using Chart Patterns
There are several chart patterns that can help you indicate these breakouts. Some of these include head and shoulders pattern, double top or double bottom pattern, triple top and triple bottom pattern, and others.
Trading Breakouts using Trend Lines
Drawing trend lines on a chart make it easier to spot possible breakouts. What you need to do to draw a trend line is to simply connect at least two tops or two bottoms together with the help of a line which is then called your trend line. Connecting two tops or bottoms is the minimum requirement; however, the more they are the better it is as it increases the strength of the trend line.
Below is an example of a chart that shows a line that connects three tops which is named as a Falling trend line.
To take advantage of these trend lines for trading breakouts you need to understand tow basic things that can happen once the price starts to approach your trend line. One, it is either going to bounce off and continue the trend or two it is going to break through the trend line and you are going to witness a reversal.
This trend line can and should be used with other indicators and techniques that you have in your forex toolbox to reach a decision to trade a certain currency pair or other asset class that you are sure of.
Trading Breakouts using Channels
Like channels, trend lines are also a great way to devise profitable strategies by attentively following any breakouts in the current trend pattern. They are drawn in almost the same way as trend lines, except the fact that in trend channels you have the ease of spotting breakouts on either direction of the trend as there are two lines drawn; one connecting the tops and the other connecting the bottoms.
The approach to identifying breakouts in trend channels is also similar to trend lines, as we wait for the fluctuations in price to break through any one of the trend channels.
Trading Breakouts using the Triangles
Triangles basically refer to the idea of the movement of prices in the market. When market prices start off with major variations and fluctuations but then starts to consolidate because of low volatility, a triangle is formed. What you need to do as a forex trader is to place your position and trade in the market when it is in the consolidation phase and then wait for a breakout to occur to reap the benefits of your profitable strategy.
Triangles that form on these price charts are of three types.
This type of triangle is formed when higher lows have started to form because of the prices in the market. This shows that a bullish sentiment has started to gain momentum in the market and a resistance level has formed. These higher lows, however, are formed as a result of traders who after the price reaches a certain high start believing that this is the maximum it would get and hence start selling which drops the price back down. On the contrary, there are other traders in the market who believe that the prices shouldn’t drop and should be higher and therefore the prices start to climb again as these traders start buying in the market.
This is the reason why ascending triangles are known to give bullish signals. And once the resistance level that was previously formed is breached causing a breakout, it is mostly recommended to go long on this position. Below is a chart that explains this scenario.
These triangles are opposite of ascending triangles. They are considered to be bearish signals as the prices that are dropping down form lower highs that are met by a support level. Once the market prices breach the support level, this is exactly the point where you can spot a breakout. Here it is recommended to go short.
This is a type of triangle where both buyers and sellers, bulls and bears, are at a constant war with each other which results in higher lows and lower highs that forms a converging point somewhere in the middle. The chart below shows how it looks like to get a better understanding of the concept.
Because of the apex that this triangle forms it does not give any signal and does not have any directional bias. This is why on such a formation of a triangle you should always be ready to take a position on any side of the market as there is an equal possibility that the price could break out on either of the sides.
Breakouts are what are famous among every forex trader, broker, and analyst and why wouldn’t they? They provide you with the opportunity to take benefits of all the possible breakouts that can be termed as your profitable strategies.
But these breakouts are not there to stay forever. When you start believing that everything is going well, that is when things start moving in the opposite direction which is then known as a fakeout in the forex world. These times are called the failure of breakouts and you as a trader should know what to do in such a situation.
In order to avoid fakeouts you need to fade the breakouts. This means you need to trade in the opposite direction of the fakeout. Fading breakouts also is called as trading false breakouts. This is mostly done when you believe that there had been a false breakout from a support or a resistance level.
Times when a significant breakout happens through a support or a resistance level, fading breakouts may prove to be smarter than trading the breakout. However, you should always bear this in mind that fading breakouts serve best as a short-term strategy.
Breakouts may fail in the short term but they are a great long-term strategy. They fail in the short-term because the smart minority, who are the big players with big accounts and large buy/sell orders, make money off the majority. This is because while everyone wants to buy or sell in the direction of the breakout, these big fishes play on the opposite side of the market becoming the market makers.
These market makers are more seasoned traders, are institutional and considered to be smart minorities who prefer fading breakouts. This is why it is said that trading alongside these market makers could be more profitable and would let you gain more advantage of the collective thinking of the crowd by winning at their expense.
To trade fakeouts, you need to have an idea as to where these fakeouts may occur. Usually, they are found at support and resistance levels that are formed with the help of chart patterns or trend lines.
Trading Fakeouts with Trend Lines
When trading fakeouts or false breakouts it is necessary that the trend line and price should have space between each other. This shows that price is moving away from the trend line but more in the direction of the trend. Such a situation provides more opportunities for trading fakeouts.
Trading Fakeouts with Chart Patterns
The two common chart patterns where false breakouts of fakeouts may occur are double top and double bottom pattern or a head and shoulders pattern.
Fading the breakouts in these range-bound environments can prove to be very profitable.
Sources for Graphs and Charts