Trading breakouts is a successful trading strategy if you can manage your risk appropriately. However, as you recently learned, many traders do not manage risk appropriately. For traders who love to trade breakouts, but can't manage their risk, a failed breakout can be their worst enemy, but lucky for you, this article will tell you how to manage risk and focus on a flip in sentiment for opportunity.
Why Trading Breakouts Is A Legitimate Strategy
The forex market is prone to many strong trends that begin with a breakout from a long-term range. The reason for these long-term trends are many but the most advantageous breakouts that advanced traders and investment bank trading desks look to is monetary policy divergence. Monetary policy divergence happens when one central bank like the Bank of England has an optimistic look on the economies future and by communicating their optimism strengthens their currency. If this occurence happens while another central bank is cutting interest rates or communicating that they may weaken their currency in the months ahead to ease the strains on their economy, this can weaken the currency and when put against the strong currency can result in a strong trend that can last for years.
A breakout can be identified by looking a price ceilings or resistance and price floors or support. When price breaks, closes, and holds for a period of time above resistance or below support a breakout has taken place. A breakout signifies a shift in the market where one side, bulls or bears, has lost the battle, and the side in favor of the breakout is about to takeover. This has most recently happened on USDCAD, which YTD has been one of the strongest trends when USDCAD broke above its 2010 high of 1.0855 and hit 1.1224 only a few weeks later for a quick 375 pip move.
The Two Ways A Breakout Can Be False & Trigger an Opposing Signal
"An important rule of trading is that time is much more important than price."
-Mark Fisher, The Logical Trader
You were just told that there are three ways to identify a legitimate breakout. In working with many traders, I've noticed that they often pay attention to only one qualification of a breakout. The three components of a breakout worth trading in the direction of is a price break that can be identified by a tool like the Donchian Channels, a close above the key level in the direction of the break, and third, a specified time that price holds in the new price zone.
If price only spends a short time above prior resistance before breaking back below into the prior zone, you may have just witnessed a false breakout. If you've entered in the direction of the false break as identified by price not spending time above resistance or below support for a qualified amount of time, then it is best to exit and wait for clarity on the move before re-entering.
Many traders do not understand the importance of price in trading but if you apply this rule to other areas of life, you can see how much sense this makes. Think about it, the longer something takes hold in popular culture; the more accepted it is a current reality. If something happens overnight, and spends only a short time in the spotlight, it is said to have its 15-seconds of fame before the world returns as it were. In the markets, false breakouts often happen on a news shock but if price doesn't hold the breakout levels for a specific amount of time, then it's best to standby.
Recent False Breakout That Time Did Not Honor
In the first few months of 2014, the FX market experienced a mini-crisis. The mini-crisis was in the realm of Emerging Markets or EMFX as well as smaller G10 currencies. However, as soon as the fear came, which caused many headliner EMFX crosses to move violently like the Argentinian Peso, Hungarian Forint, & South African Rand of the Norwegian Krone to name a few, have fallen back below breakout levels signaling a potential and likely false breakout.
Because the USDOLLAR has recently shown a bout of weakness as EMFX is starting to stabilize, evidence is building that the breakout on some of these crosses may not be sustained. Another measure you can look to that many advanced traders also look at to see if a breakout will be sustained is the VIX or volatility index that can enlighten you to see if that the environment that nurtured the prior trend may be changing.