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There are dozens of breakout strategies available to traders, but the Forex breakout strategy you’re about to learn is my personal favorite. This strategy has been responsible for some of my largest gains over the years.
In this lesson, you will learn how to identify the setup, when to enter the market as well as how to identify possible targets. We will also take a look at several examples on both the 4-hour chart as well as the daily chart. I have found these two time frames to work best when trading this breakout strategy.
Before we get into my favorite Forex breakout strategy, let’s first define the term, “breakout”.
A breakout is any price movement outside a defined support or resistance area. The breakout can occur at a horizontal level or a diagonal level, depending on the price action pattern.
Let’s take a look at two illustrations of one of the more common breakout patterns that occur in the Forex market. The first illustration shows a bullish breakout pattern.
Notice in the illustration above, we have a market that is trending up but has found resistance at a horizontal level. After two unsuccessful attempts, the market finally breaks through resistance. This signals a bullish breakout from a key resistance level.
The next illustration we’re going to look at involves a bearish breakout.
Just as you would expect, the bearish breakout is similar to a bullish breakout, only this time the market breaks to the downside. After two unsuccessful attempts, the market finally breaks through support. This signals a bearish breakout from a key support level.
The reason these breakouts are such an important trading strategy is because they often represent the start of increased volatility. By waiting for a break of a key level, we can use this volatility in our favor by joining the new trend as it begins.
This particular Forex breakout strategy is one I have used for years. It has become my favorite pattern to trade, partly because of its reliability and partly because of the more than favorable risk to reward ratios it often produces.
There are four parts to this Forex breakout pattern.
The illustration above is very similar to the first two illustrations. The major difference here is that instead of having one trend line and one horizontal line, we have two trend lines. One trend line is acting as support while the other is acting as resistance. This forms what’s known as a “wedge”.
The breakout to this pattern occurs when the market eventually breaks to one side or the other. While a wedge is typically a continuation pattern, I tend to trade it based on whichever way the market breaks. In other words, I let the market show its hand before making any considerations about future price movement.
Now let’s apply this same pattern to a USDJPY 4-hour chart.
Notice how in the chart above, the market had worked its way into a wedge pattern. As the market began to consolidate tighter, it eventually broke wedge support and subsequently retested this support level as new resistance.
This retest presented traders with a perfect opportunity to enter short.
To get a good idea of the setup in action, let’s take a look at each step including the entry strategy and where to place your stop loss.
Most times your entry will come on a retest of former support or resistance. However, it’s important to note that depending on how strong or weak the market is, you may not get a retest. We will discuss this in greater detail later in the lesson. For now just know that it’s best practice to enter on a retest of former support or resistance, depending on which way the market breaks.
Your stop loss should be placed above or below the breakout candle, at a minimum. In the case of the USDJPY breakout pattern below, your stop loss should be placed above the candle that broke support.
In the chart above, the market broke wedge support on the breakout candle and subsequently retested former support as new resistance. This retest presented an opportunity to get short with a stop loss above the breakout candle.
Now that we know where to enter and where to place our stop loss, let’s discuss how to set a target. As you may well know, I’m a huge fan of using simple price action levels. So you can probably guess how we’ll go about setting a profit target.
Here is a much broader look at the USDJPY chart. This time, we’re looking at the daily time frame to see if we can identify a logical target for our breakout trade.
The first thing you’ll notice is the strong support area that has been in place for several months. This makes for an ideal area to target for our trade setup.
So what kind of risk to reward ratio did we get out of this trade setup? Let’s take a look.
In the USDJPY 4 hour chart above, we can see that the stop loss was 13 pips from the entry while the take profit was 50 pips from the entry. This gives us a 3.8R (50 / 13). In other words, if you had risked just 2% on this trade, you would have made 7.6% (3.8 x 2%).
While that’s an impressive gain on its own, what’s even more impressive is the fact that you would have made 7.6% in just 32 hours.
Let’s turn our attention to another example of the Forex breakout strategy. This wedge pattern occurred on the GBPNZD 4-hour chart. One major difference here is that there was no retest of former support once the market broke to the downside.
Notice in the GBPNZD chart above, the market failed to retest former support before dropping 430 pips. But just because the market doesn’t retest former support doesn’t mean we have to miss the trade.
The retest that we look for as part of this Forex breakout strategy typically comes within the next few candles. So if the market begins to move sideways for more than three or four periods, there’s a good chance that the market won’t give a full retest.
Let’s take a closer look at the GBPNZD trade setup.
In the GBPNZD 4 hour chart above, notice how the market begins to move sideways for several periods. This is a good indication that the market lacks the strength to retest former wedge support. When you see this happen, it’s generally a good time to use a market order to join the forthcoming trend.
Here is the GBPNZD breakout trade from start to finish.
For this setup, our stop loss was 45 pips from the entry. Remember that you want your stop loss above or below the breakout candle. Because this is a short setup, our stop loss was placed above the breakout candle.
Our take profit, on the other hand, was 175 pips from the entry. The target was identified by the recent low which was made several weeks prior. Note that the market gapped down the following week and ran for another 150 pips before reversing.
Although this looks great in hindsight, the logical target at the time was 175 pips away, which still produced a very healthy 3.9R trade. So if you had risked 2% on this trade, you would be left with a profit of 7.8%. This particular setup took just 36 hours from start to finish – not bad to be able to make a 7.8% profit in 36 hours while only risking 2%.
As I bring this lesson to a close, I want to leave you with one last setup. This particular breakout occurred on the USDJPY daily chart and represents what’s possible with the Forex breakout strategy you learned today.
The first thing you’ll notice is the length of time the market consolidated within this wedge pattern before breaking higher. The setup above formed on the daily chart, so from start to finish this consolidation period lasted for 180 days.
This brings me to an important observation about the Forex breakout strategy – the longer the market consolidates, the more volatile the breakout will be. This isn’t always the case, but 9 times out of 10 the market respects this idea of matching the length of consolidation to the level of volatility.
For those who were able to get in this trade at the breakout point and ride the trade until the consolidation period (take profit level) there was a massive gain to be had. A stop loss below the breakout candle meant a 50 pip stop with a potential gain of 600 pips. That works out to a very healthy 12R trade. At just 2% risked you would have made a staggering 24% profit.
Although rare, these 10R+ trades do happen from time to time. And with the knowledge you’ve gained in this lesson, you will be able to identify and profit from these patterns with ease.
I hope this lesson has opened your eyes to what’s possible with a simple Forex breakout strategy. Just remember that like any other trading strategy, this breakout strategy is not without flaw. Therefore always be sure to maintain a proper risk to reward ratio and use a favorable stop loss strategy on every trade.
We covered a lot of content in this lesson. Here are some of the highlights to keep in mind as you begin to implement this trading strategy into your game plan.
Do you use a similar Forex breakout strategy? Or maybe you just have a question about this lesson. Either way, I’d love to hear from you.
Leave your comment or question below and I will get back to you within 24 hours.
Justin Bennett is an internationally recognized Forex trader with 10+ years of experience. He's been interviewed by Stocks & Commodities Magazine as a featured trader for the month and is mentioned weekly by Forex Factory next to publications from CNN and Bloomberg. Justin created Daily Price Action in 2014 and has since grown the monthly readership to over 100,000 Forex traders and has personally mentored more than 3,000 students.Read more...
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