This week’s question comes from Tejas, who asks:
After a breakout has occurred, should we wait for a retest of that area before buying or selling?
From my experience, this is the most highly contested topic when trading breakouts in the Forex market. After all, everything else when trading a break of support or resistance is pretty straightforward.
There are a few things you should keep in mind when deciding when and where to enter.
The three factors below will no doubt help you the next time you encounter a breakout opportunity. And let’s face it, an ill-timed entry can easily result in a loss even if you have the direction right.
That makes your decision of whether to wait for a retest paramount to the viability of your strategy.
1. Where Is the Mean?
This is perhaps the most important factor when deciding whether to enter immediately or wait for a retest following a breakout.
For those who have followed me for a while, you’ve no doubt seen me write about mean reversion. It’s a rather simple concept that can be illustrated in a variety of ways.
Some may use sophisticated algorithms while others like myself choose to use a more simple method. But first, let me explain what the mean is with regard to price action.
We all know that markets ebb and flow. These are the natural swing highs and lows of any financial market.
And although markets are unique in their composition as well as order flow, one thing is always the same – they always return to the mean.
The mean is the “central” value of a set of numbers. So if we were trying to figure out the mean of a set such as 1, 2, 3, 4, we would add the numbers together and then divide by four.
(1+2+3+4) / 4 = 2.5.
Now, when it comes to trading, this central value is represented as a price within a specified period. For example, the mean for the EURUSD will vary depending on whether we’re looking at the last two days or the past two weeks.
But instead of crunching numbers all day, I prefer an easier and more visual method.
While this method can be useful on a 4-hour chart, I much prefer its use on the daily time frame. This applies in particular when a market is trending.
Knowing that markets like to return to this area over time makes deciding how to enter a breakout much easier.
Take the EURUSD daily chart below as an example.
As you can see from the chart above, the pair broke trend line support on a daily closing basis.
However, by the time the session closed the Euro was still 150 pips below the mean. This meant that a pullback over the coming sessions was the most likely scenario.
Sure enough, within the next few days, the pair returned to the mean and also retested former support as new resistance.
The chart above is a perfect example of how waiting for a pullback to the mean can keep you out of trouble. By waiting, we were able to secure a much better entry.
2. Is the Risk Worth the Potential Reward?
In trading, and in life, there are two types of risk – absolute and relative.
Absolute risk is usually defined by pips, a percentage of your account balance and a dollar amount.
Relative risk, on the other hand, adds another dimension. With this type of risk, we combine the potential reward of the given setup. This comparison is what provides you with the risk to reward ratio for the trade.
Now, when it comes to trading, we need to use both forms of risk. One or the other simply won’t cut it.
There are two things we need to figure out before placing a trade.
- How much of our account balance should we risk?
- Is the risk worth the potential reward?
Absolute risk on its own is somewhat useless. For instance, let’s assume you’ve decided to risk 1% of your account or $50 and have a 100 pip stop loss.
That’s all good and well, but if you then told me your target is 20 pips away, I would say that’s a bad bet. You’d essentially be risking $50 to make $10.
Now, if you told me your target is 300 pips away, that’s a bet worth taking. In that case, you’d be risking $50 to make $150.
The notion of relative risk alone can sometimes be enough to determine whether you should wait for a retest following a breakout. If your target is too close in relation to the required stop loss placement, you probably need to wait for a retest before considering an entry.
I advocate a minimum two to one reward to risk ratio. In other words, if you need a 50 pip stop loss, the target should be no less than 100 pips away from your entry.
With that said, for the last few years, I’ve personally used a three to one ratio. But for swing trades that are likely to last a week or longer, I prefer a ratio of five to one.
Also, remember that waiting for a retest of the broken level can give you a place to hide your stop loss. Because until the market tests that level as new support or resistance, there’s no telling how far it might backtrack.
So the next time you find yourself questioning whether waiting for a retest is appropriate, ask yourself if the risk is worth the reward.
The following questions come to mind.
- Where will you place your stop loss?
- Is that stop loss placement ideal or are you just guessing?
- Is the reward to risk ratio at least two to one?
These are all questions you should be asking before you enter. In many cases, an evaluation of the relative risk will help you determine whether waiting for a retest is appropriate.
3. Find What Fits Your Personality
If mean reversion is the most important factor, finding what suits your personality is the most overlooked.
How many times have you searched for the following terms in Google?
- Best Forex strategy
- Forex strategies that work
- Best Forex strategy for consistent profits
- Profitable Forex strategy
Come on; you know you’ve searched for these terms or something similar over the years. I certainly did before I found price action many years ago.
But here’s the thing…
There is no single best way to trade Forex or any other market.
Some may contend that statement, but they’re only challenging what works best for them because no universal strategy outperforms all others.
Look no further than the Market Wizards series of books by Jack Schwager. He’s interviewed dozens of the world’s best traders over the years, yet each one has their own unique style. In fact, some of the methods he describes directly contrast others.
The only logical explanation is that there is no single best strategy. It all comes down to finding what fits your personality.
With this in mind, we can say that the best strategy is the one that works best for you.
So when it comes to timing breakouts, there is no single right way to do things. And the only way to find what suits you best is to experiment using various methods.
There is no single market secret to discover, no single correct way to trade the markets. Those seeking the one true answer to the markets haven’t even gotten as far as asking the right question, let alone getting the right answer.
Jack Schwager – Author of Market Wizards
Deciding whether to wait for a retest of a key level following a breakout is a highly personal decision. It’s a question that can only be answered with practice over an extended period.
With that said, a study of mean reversion is an excellent place to start. All financial markets have a mean, and they always return to it over time. Be sure to take this into account when evaluating whether a retest of a key level is likely.
Another way to determine if you need to wait for a retest is to assess the risk to reward ratio for the given setup. I consider a favorable ratio anything above one (risk) to two (reward). So a 100 pip stop loss requires a 200 pip target.
At the end of the day, it’s about finding what works best for you. There is no single best way to trade Forex or any other market. The best trading style is the one that works best for you.
Your Turn: Ask Justin Anything
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:
- Ask questions. Post them in the comments below or Tweet them to me @JustinBennettFX
- Help me answer questions. If I missed something or if you have something to add, don’t hesitate to leave a comment below.