Support and Resistance Breakout
Once in a while, I hear someone say that breakout trading worked best in the late 1990s in the stock market. Well, someone who learned to trade in the late ‘90s and who does not understand breakout trading might say that. In those days, you could buy anything at almost any time or price and make money. Today, breakout trading is where you see most of the money being made in Forex trading by those who truly understand the structure behind a true breakout.
Recently, my articles have been focused on various strategies I have seen traders using and finding success with. In this article, we will look at far and away the most popular entry strategy, the “breakout.”
The above chart shows the EUR/USD. Notice the horizontal resistance line on the chart and let's work left to right in our understanding of what is really happening behind the candles in this chart. The first circled pivot high on the left becomes a pivot high because supply in this market exceeded demand at that price level. When price reached the line, some of the sellers making up supply at that price get to sell, but there is still much more supply than demand so price has to fall to a lower level.
The drop from the first circled area was significant, as we would expect. The second time price revisited the resistance level, it declined again but this time, the decline was shallow compared to the first time. This was because each time the resistance level is revisited, more sellers that make up supply get to sell, so the supply and demand equation is becoming more balanced.
The analogy here is ‘chopping down a tree’ (not a great example, I know). With each chop, ‘mass’ is removed from the ‘tree’ and the tree becomes more likely to fall. In trading, the ‘mass’ is ‘supply and demand.’ Moving left to right, price comes back to that level a third time and falls once again, but the decline is shallow suggesting that there are not as many sellers remaining at that price level.
Next, price revisits the price level a fourth time but, instead of declining from that level, it bases sideways suggesting there are no longer more sellers than buyers. This is when you get ready to buy because in Forex trading (and any other market for that matter), price is likely to move higher. One would feel comfortable taking a low risk entry on a breakout here as the objective price action tells us that there are simply few sellers if any left at the resistance price level.
Does every trade work? Of course not – we are talking about trading here! This is why it is so important to understand what is driving the movement of the candles. This helps you understand the structure of a breakout. For a short position, we would just do the opposite of what I am suggesting here. If you want to see an example of a shorting opportunity, print this page out and turn it upside down.
The Trend Line Breakout
Trend line breakouts and breakdowns are a very popular entry strategy in Forex and other markets. Much of the time, this is the only type of entry a student will practice in class all week long because they become comfortable with it as it is simple to understand and can produce some strong moves.
This is another chart of the EUR/USD currency pair. The down trend line is drawn using two points on the chart, which is what is always required when drawing trend lines. Once the two points are evident and the trend line is drawn, simply wait for price to breakout above the line for a long entry. The logic here is that price is trending down because it is at price levels where supply exceeds demand.
We want to buy this market when it reaches a price level where demand exceeds supply (more buyers than sellers). Instead of trying to guess at where this might be, the price action on the chart will tell us where this price level is if we just wait and watch. When price eventually breaks out above that down trend line, it happens because it has reached a price level where there are more willing buyers (demand) than sellers (supply). This is where we would want to take a low risk entry and buy.
While there are many profit taking targets, one logical target for profit is the origin of the decline in price that started the whole downtrend in the first place. This is shown as the dashed red line on the previous chart.
The above chart shows a steep uptrend in the price action and our uptrend line. Instead of guessing as to where this dramatic advance in price might end or at what price level all the supply is resting, draw an uptrend line by connecting the pivot lows and look to sell short on a breakout (breakdown in this case) of that line. As in the last example, a natural target can be the origin of that rally in price as shown by the dashed red horizontal line on the bottom of this chart.
Keep in mind that the most important part of trading is the proper management of risk. The focus of this piece has been to help with market entry as that is the beginning of a good risk-averse strategy. The breakout entries discussed in this article are equally appropriate in any and all markets so do not think this is just for Forex.
Never forget, whether the market candles on a screen represent a chart of stocks, futures, Forex currencies, options, football trading cards, rare coins or anything tradable… they are all just people and price. A breakout in price would be quantified the same way in any and all of these markets. If you are watching the buying and selling of a David Beckham rookie card and see that the last one available at the current price level just sold, what is about to happen to price?
excerpt from forexjournal.com
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