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This week’s question comes from Margaret, who asks:
How do you define a breakout in the Forex market?
I would bet that most Forex traders can identify a breakout.
As the name implies, it’s when a market breaks out from a key support, resistance level or technical pattern.
Sounds simple enough, right?
But what if I told you that most traders get it wrong? In fact, my description above is incomplete without mentioning one key factor.
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In today’s post, I will discuss and illustrate how I define a valid breakout, including the type of chart I use, and why it’s so important.
I’ll also get into whether or not you should wait for a retest following the breakout. While the answer is subjective, there are two critical factors that can help you decide which path to choose.
Without further ado, let’s begin!
If you’re an experienced trader, you can probably move to the next section. However, if you’re in any way unsure of what it means for a market to break out, you will want to read the next few paragraphs.
A breakout simply refers to the point when a market breaks beyond a key support or resistance level. It can be part of a technical pattern such as a channel, a horizontal level or even a trend line.
As price action traders, these breakouts are a critical component. They help us determine where the market is likely to go next.
Most breakouts occur after a period of consolidation. Once the market is ready to continue trending, price breaks through a key barrier, representing an opportunity to buy or sell.
The Forex market is full of noise. Everything from a rate decision and statement to non-farm payroll can cause disruptions.
However, these events also move the market, so they aren’t all bad. If it weren’t for market moving announcements, you and I would be pretty bored and perhaps out of a career.
You may be wondering, what is “intraday” noise?
The term intraday means within one day. When discussing events like the ones above, it refers to the volatility caused by an event within the 24-hour period that begins at 5 pm EST.
As you may well know, I use New York close charts. That means that each 24-hour session opens and closes at 5 pm EST.
The advantage is that I have five 24-hour periods each week. That may seem trivial, but I can tell you from experience that if you’re trading from anything but New York close charts and utilizing price action signals, you’re going to run into false positives.
In other words, your chart may show a buy or sell signal, but the rest of the market, including the professionals, don’t see it that way.
So what does this have to do with breakouts in the Forex market?
In a word, everything. That close at 5 pm EST is the breakout. If the market can’t clear a support or resistance level at the close, it is not a confirmed breakout.
Here’s an example on the EURJPY daily time frame:
Notice how the market moved above key resistance intraday, but wasn’t able to close the session at 5 pm EST above resistance.
Therefore, the price action above does not represent a confirmed breakout. Yet I guarantee there were plenty of buy stop orders just above resistance during this time. Those positions never stood a chance because of the head fake in the chart above.
Now, here’s what happened just a couple of weeks later:
After a few intraday spikes above the level, the EURJPY managed to close the day above resistance. Once this occurred, you could begin watching for a buying opportunity on a retest of the level as new support.
What followed was a 300 pip rally.
If you take nothing else away from today’s lesson, let it be this…
When it comes to breakouts, the daily close at 5 pm EST is all that matters. Everything else that occurs intraday is just noise and is therefore insignificant.
Now that you know to use New York close charts and how to avoid the intraday noise, let’s discuss retests for a moment.
One of the most common questions I receive is, should I wait for a retest of a broken level before entering?
To be honest, there is not only one correct answer. Every trader has to determine what works best for him or her.
That said, there are a couple of considerations when deciding which approach you should take.
The concept of mean reversion in trading refers to the assumption that a market will return to its average price over time. This is one factor I have seen many traders neglect.
Take the chart below as an example.
In this case, I’m using the 10 and 20 exponential moving averages (EMAs) to identify the daily mean, or average price.
During an uptrend, the AUDUSD moves considerably higher in a short period, creating space between the price and the 10 and 20 EMAs.
I call this space an overextension. So if you ever see me write that a market is overextended, I’m referring to the vast distance between the current price and the EMAs.
The same concept applies during a downtrend. The market makes sharp moves downward, but eventually reverts back to the mean as represented by the 10 and 20 EMAs.
When deciding whether or not to wait for a retest, you should always ask yourself, where is the mean?
If it’s relatively close to the current price, you may be able to enter without waiting. However, if the market is overextended, chances are you’ll get a retest of some sort before the next leg materializes.
After you’ve identified the distance between the current price and the mean, the next thing you want to determine is the risk to reward ratio.
I personally use a three-to-one reward to risk ratio as a minimum for any setup.
What does that mean, exactly?
It means that the potential reward of a setup must be at least three times the risk. Otherwise, I’ll dismiss the setup and look elsewhere.
So, if the stop loss is 100 pips from the entry, the reward must be at least 300 pips away. You can also use a two-to-one ratio, but I wouldn’t go any lower than that.
Spotting a breakout in the Forex market seems easy enough. You wait for the market to move above or below a key level, and then look to trade in the direction of that move.
However, a true breakout is much more than that. It requires patience to wait for the daily session to close at 5 pm EST. Otherwise, you run the risk of entering too soon and getting caught on the wrong side of the market.
The fastest way to improve your trading is to start waiting for each 24-hour session to close before further deliberation. That means waiting for the New York close at 5 pm EST. It removes a lot of the intraday “noise” and slows your trading down, which is a good thing.
I’d love for this new weekly Q&A to be successful and provide an invaluable repository of answers to common Forex questions.
To do that, I need your help.
Here’s what you can do to get involved and have your question answered in next week’s post: