One of the most common questions I receive is, should I wait for the retest of a broken level or enter immediately following the breakout? In other words, if a currency pair breaks out from a head and shoulders pattern, should you wait for a retest of the neckline as new resistance or simply enter once the day closes below the level?
While the answer is fairly subjective, there are a few “golden rules” that can help you decide whether to enter on the breakout or wait for a possible retest. Today’s lesson will cover three simple rules that should always be factored into your decision-making process.
But before we begin I want to be clear that this style of trading (entering without price action confirmation), is a bit more advanced than waiting for a pin bar to form after the market breaks a key level. So if you are new to price action, I recommend that you start with the lesson on pin bars and really perfect that strategy before you consider using the two entry methods in this lesson.
With the disclaimer out of the way, let’s dig in!
Breakout vs. Retest
Obviously, you can have both a breakout and a retest of the broken level. However, for purposes of this lesson, we will refer to “trading the breakout” as a method of trading where one does not wait for a retest of a broken level before entering the market.
On the flip side, “trading the retest” means waiting for a broken level to be retested as new support or new resistance before entering the market.
The diagram below illustrates the difference.
A quick glance at the illustration above may have you wondering why anyone would enter before the retest. After all, the name of the game is to buy low and sell high, right?
While that may be true, the retest of a broken level as new support or new resistance is never guaranteed.
Let's Be Honest, There Are No Guarantees
Like all things when it comes to trading the Forex market, there are no guarantees. The market will go up and down and you will eventually lose money just as you will eventually make money if you stay in the game long enough.
But when it comes to strategy, including entry methods, nothing can guarantee profits nor can it guarantee that the market will always play nice.
This means that if your strategy calls for waiting for a retest of a broken level, there is a chance that your order will go unfilled. You could wait weeks or even months for a level to break only to watch the market take off without you. Anyone who has experienced this will tell you that it wreaks havoc on your emotional stability as a trader.
It’s an important reality to come to terms with because some people simply are not able to sit through that in an effort to secure a more favorable risk to reward ratio. This makes the decision of whether or not to wait for a retest a very personal one, which leads us to what is arguably the most important factor and one that is constantly overlooked by Forex traders.
What's Your Trading Style? (Important)
This is by far the most important aspect when considering whether to trade the breakout or wait for a retest. Not only is it important, it’s also the most overlooked in my opinion.
Too many traders spend their time searching the internet for that magic trading formula and not enough time reflecting on what they need to succeed. In other words, identifying a style of trading that will suit their personality, lifestyle, goals, etc.
Of course in order to find a suitable style of trading you first have to experiment. But that does not include searching for the “most profitable Forex trading strategy” in Google. While this may get some ideas flowing, it will not get the job done.
What is hugely profitable to one person can likely be unprofitable to another. This is why the users of black box trading systems typically lose money over time. They may have bought a strategy that does indeed “work”, but they will never realize consistent profits because the strategy wasn’t developed with their needs in mind.
What does all of this have to do with deciding whether to trade the breakout or wait for the retest?
Everything. Some traders, based on their personality, will find that always waiting for a retest makes them more comfortable, even if that means missing some opportunities along the way. These traders must take this into account when developing their trading plan, otherwise their confidence in the resulting strategy will suffer.
At the same time, other traders will be more aggressive and thus be more comfortable taking some heat if the market does pullback as long as they are able to get their order filled. While this is not my preferred style of trading, there are those who opt for this more aggressive approach and who ultimately perform better under these conditions because it suits them.
However, while this more aggressive style may suit their needs, the traders who fall into this category need to be careful that they aren’t sacrificing a favorable risk to reward ratio in order to get filled.
This brings us to yet another extremely important factor.
A Favorable Risk to Reward Ratio Is a Must
The practice of only taking trade setups where there is a favorable risk to reward ratio is perhaps the most important aspect of becoming a successful Forex trader.
What is considered favorable, you ask?
While the answer is highly personal, I always look for at least a two to one ratio where the potential reward is at least twice the risk. In terms of an R-multiple, the ratio of two to one can be simplified and written as 2R.
Before we move on, I do want to stress the importance of finding your own minimum R-multiple. While I teach 2R as a bare minimum, I typically only trade 3R or better setups in my own account. This forces me to be more patient and look for the larger, more lucrative opportunities in the Forex market.
Another way of structuring your risk to reward is something that Bill Lipschutz, a highly successful Forex trader, does in his own account. Here is an excerpt from an interview with Bill where he explains his approach.
With a trade you always look at a multiple upside to downside. But how much greater? A good rule of thumb for a short-term trade – 48 hour or less – is a ratio of three to one. For the longer-term trades, especially when multiple leg option structures are involved and some capital may have to be employed, I look for a profit to loss ratio of at least five to one.
Regardless of how you structure it, your minimum R-multiple will occasionally be the deciding factor of whether you need to wait for a retest or not.
The illustration below shows this idea in more detail.
Notice how the distance from the breakout to the hypothetical stop loss level is 200 pips. The distance from the new support level to key resistance is also 200 pips.
This means that if your minimum multiple is 2R, you would be forced to wait for a pullback in order to satisfy your requirement. Otherwise you would be taking a trade with a potential profit of 100 pips while risking 200 pips.
Know Your Currency Pairs
Last but not least is the particular currency pair you are trading. As you know, each currency pair has its own personality. Some tend to trend nicely more often than not while others, particularly the Yen crosses, tend to be a bit more volatile and choppy.
While I would love to be able to give you a list of what to do for each currency pair, the reality of the Forex market’s inner workings is not quite that simple. While some currency pairs or even baskets of currency pairs exhibit certain characteristics, the specifics of those characteristics are dynamic and are therefore constantly changing.
This makes it extremely important to pay attention to how previous price action of the pair you intend to trade has reacted over the past few weeks or months. The daily time frame makes this easy by allowing you to view the previous few weeks or even months in one window to see how often each day’s advance or decline is overlapped by the following day.
The illustration below shows a comparison of two markets that have recently broken key resistance but exhibit vastly different day-to-day movement.
Notice how the first chart in the illustration above shows a currency pair where the price action is quite choppy. When trading such a pair, it’s often best to wait for a retest of a broken level before considering an entry. This is because the characteristic of how each day overlaps the previous day is likely to remain intact even after the pair breaks through resistance.
On the other hand, the chart in the lower portion of the illustration shows a currency pair that is much more “clean”. In other words, each day is less likely to overlap the previous as the market trends higher. In this case, a retest of the broken level as new support is less likely.
Another point of consideration here is the momentum. The momentum in the second chart appears much stronger than that of the first. Therefore the odds that the second market will pull back into support is less than that of the first market, where the bullish momentum is not as strong.
There are many factors that play into whether you should trade the breakout or wait for a retest with the most important one being your trading style. This takes the number one spot because your confidence in your trading style will only go as far as your comfort level with that style.
Always remember that a favorable risk to reward ratio should never be compromised in order to get a fill. Without a favorable ratio there is no trade setup. This alone will sometimes force you to wait for a retest of a broken level before considering an entry.
Paying attention to how each currency pair moves is what being a price action trader is all about; and it will make your decision of whether or not to wait for a retest that much easier.
At the end of the day it isn’t about finding what works best, it’s about finding what works best for you. The only way to do that is to try various methods until you find something that fits your needs. Only then can you begin to build your foundation for trading success.
Do you wait for the retest of a broken level or are you more inclined to trade the breakout?
Leave your comment or question below. I look forward to hearing from you.