Should You Wait for a Retest Following a Breakout?

Waiting for retest

Happy Friday!

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.

Let’s begin.

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.

The 10 and 20 exponential moving averages (EMAs) are my go-to mean reversion tool. At any given time, the area between these two averages represents the mean for the currency pair in question.

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.

EURUSD breakout

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.

EURUSD retest

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.

  1. How much of our account balance should we risk?
  2. 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

Final Words

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:

  1. Ask questions. Post them in the comments below or Tweet them to me @JustinBennettFX
  2. Help me answer questions. If I missed something or if you have something to add, don’t hesitate to leave a comment below.

Leave a Comment:

31 comments
Maninder Singh says

Hi Justin, when we know that a market is retracing the most difficult question that arises is how much would it retrace? Shall we want to see a candlestick pattern at the end of the retracement? Or just enter when it reaches the mean? A broader question that arises from here is whether it is reversing? Coz a reversal can’t be conformed untill it breaks the HL or LH

Reply
    Justin Bennett says

    Hi Maninder, thanks for your question. I’ve added it to the list for future Q&A segments.

    Reply
Diana says

How do you determine on which TF the trend has ended? Do you use two TF?

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john njoga says

Justin
Thank you for your post. I did not know there is a relationship between a pullback and the position of the EMAs. Two questions;
1. why 10 and 20 EMAs?
2. How to determine potential profit targets?
Have a good Easter weekend and looking forward to your next article.
John
.

Reply
    Justin Bennett says

    You’re welcome, John. I’ve just found the 10 and 20 EMAs to work well. As for determining profit targets, that’s a bit harder to answer, but I’ve added it to the list. Thanks.

    Reply
Basil says

Hi Justin
My UK broker (IGindex) offers a simple UP or DOWN Binary trade on fx, commodities, stocks etc. To make GBP80 profit I have to bet GBP100. Expiry ranges from from 2 minutes to 1 hour. This does not meet your minimum 2 to 1 ratio. Am I wasting my time here?
Your health
Basil

Reply
    Justin Bennett says

    Hi Basil, that isn’t a question I can answer. I’m not familiar with your broker or how you’re currently trading.

    Reply
imre klein says

Hi Justin!
I am just wondering if you provide forex signals to novice traders like me?I just can’t afford to lose my hard earn money.
/I earn a minimum wage of $300/month in my country-Hungary./ Is it possible to become a good forex trader with an initial investment of $500 or is it just a waste of time and money?Most of the time i am wrong in trading forex. My Win/loss ratio is 10/90. 🙁 I want to be a profitable forex trader so hard and i know YOU are the key for that with your knowledge. /Price action on a daily chart fits very much my personality./
Please advice me. Many-many thanks,Justin!
I wish you a wonderful Easter holiday! Take care,Imre Klein

Reply
Aidan says

morning Justin hope you are well. I was just wondering when i join you how will i get hold of the chart software you use .Please Advise, Wishing you a good Easter.

Best Regards.

Aidan.

Reply
    Justin Bennett says

    Hi Aidan, if you’re referring to MetaTrader, most brokers offer it as a platform. Cheers.

    Reply
vincenzo says

Great Report Justin and thanks.

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MIMI says

Thanks Justin – always great to read your inputs/reports as you make them super easy to understand!

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Annas says

sir kindly write article about correlation of currency pairs. Thanks

Reply
Lubba says

Hi Justin

I trust you’re having a lovely Easter weekend .

I’d like to know the 10 & 20 Exponential moving averages you’re using if you apply to close, open, high, low etc ?

Reply
    Justin Bennett says

    Hi Lubba, they’re both applied to the close, which is usually the default.

    Enjoy your weekend.

    Reply
Graeme says

Thanks Justin. Great lesson thanks. I have a question. On the EUR/USD chart in your example above the market rallied for 6 days then on the 7th day there was a bearish engulfing candle. Would your strategy have been revert to the 4 hourly chart to drill down for a sell signal near the 20/10 EMA mean? or – Stay on the daily chart & wait for a daily chart sell signal near a retrace to the mean? I guess I’m asking – under what circumstances, or when should a trader be reverting down to the 4 hourly chart.

Best regards: Graeme

Reply
    Justin Bennett says

    Graeme, it depends on the circumstances. I may take a look at the 4-hour chart, but if there’s nothing obvious I’ll just stick with the daily time frame.

    Reply
Gbaluke Stephen says

Whao! I always enjoy the simplicity of your explanation. I WILL DEFINITELY JOIN your trading course as soon as I have the money. However could you tell me the set up for your EMAs. Is it Open or close, High or low, simple or exponential

Thanks while waiting for your response

Reply
Akinyemi says

I like you to do this for me A story of price action from the beginning of a move to the end of it tor a change of price say from selling a pair till the same change to buying .Thanks

Reply
    Justin Bennett says

    Akinyemi, I’m actually working on a case study lesson now. It should be out within the next week or so.

    Reply
Tejas deshmukh says

Thank you Justin for covering the topic .. Nicely written

Reply
June says

Thank you for the article… It’s easy to understand and so fun to read.

Reply
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