A popular way to earn money with support and resistance levels in the foreign exchange market is by means of a breakout trading strategy. A Forex pair often trades sideways within a fairly narrow range. This range is delimited by a support line at the bottom, and a resistance line at the top. Sometimes, however, the prices breaks out of that range after which the exchange rate shows a large rise or fall in a short period.
The breakout forex strategy uses support and resistance levels to recognize this trading setup in time, allowing you to open a lucrative trade. If you have not done so already, please read the article about support and resistance first. This lays the foundation for the breakout strategy.
Finding a breakout
To find a break-out in the chart of a Forex pair it is not enough for the price just to break through a support or resistance level. Often the price fluctuates around this level as part of the “testing”. The market then tries to find out if a previous support or resistance level is still tenable under current economic conditions.
A first signal that is needed for a breakout is when there is an entire candle opens and closes above the level of resistance (or below the support level). Preferably, it is a candle in the direction of the break-out (that is to say: the candle closes further away from the support or resistance line then it will opened). At that moment you could be opening a position on the new trend.
You should be aware, however, that there is often a “pullback” after the initial breakthrough. The price will then drop to, or just below, the previously breached resistance level, before it really starts the new trend. If you want to play it safe, you can best wait for the pullback and only place a trade after the pullback. In this way, however, you might miss some trades because there is not always a pullback.
For a breakout trade it is wise to always set a stop loss, for example at 15 pips below the breached resistance level (or above the breached support level). This is to limit your risk if the new trend does not continue. If, after the pullback, the price plunges more than 15 pips below the resistance, you can be pretty sure that the expected new trend will not continue. In that case, you should better take your (small) loss and wait for another opportunity.
When the new trend does continue, it is important to find a suitable target price. This could be another resistance level which you can find with the help of pivot points or which can be seen earlier on in the price chart. You set your take profit just a few pips below that level, so you can take advantage of the trend, but are out when the market starts to doubt again.
The breakout strategy into practice
We will now work out an example of the break-out strategy. We do this on the 4-hour chart of EUR / USD. This gives a longer-term position that is suitable for traders who do not want to sit behind their computer to monitor the markets the entire day. See the chart below. You can create a graph like this yourself with a broker like Markets.com, IG, or Plus500, to practice with breakout trades.
In the graph the EUR / USD is trading within in a range with a resistance at 1.2920. This resistance is tested several times without being broken; we thus do nothing in this aspect. Until just before P1 in the graph the price suddenly breaks the resistance. We do not buy straigth away, because we want to get confirmation for the breakthrough in the next candle. The next candle (4 hours later) opens and closes above the level of resistance, but it is a red candle, back in the direction of the range. That could be part of a pullback, or a sign that there is no lasting breakthrough. Thus, we wait and see what happens. The next candle (again 4 hours later) opens and closes above the resistance and is positive (P1). We decide not wait further on a possible pullback and open a long position. We buy the currency pair EUR / USD at the exchange rate of 1.3007.
Of course we use a stop loss for the trade, in case we’re wrong. Because we use a 4-hour chart, which larger price fluctuations, we set the stop loss 40 pips below the resistance at 1.2880. If the price falls back to that level we accept it as a sign that breakthrough was a “false” breakthrough and close our position.
The next challenge is to find a suitable target price. If we look back further into the history of the EUR / USD (not visible in the chart), we see that there appears to be a new resistance at 1.3300. We therefore set our take profit at 1.3280, 20 pips below the resistance. Indeed, we do not want to be in the market if the market is in the doubt zone. Now that all the components are set, we can leave it to be. (Alternatively, you can choose to set a “trailing stop” to protect your profits.)
Successive breakout trades
In the example, the EUR / USD reaches the price target of 1.3280 after four days and our position is automatically closed. This yields a profit of 273 pips. Now we can see if there is a new breakout opportunity. Perhaps the resistance level at 1.3300 is also broken. We apply the same strategy as before and open a long position after the first positive candle which lies entirely above the resistance (P2). This results in a purchase price of 1.3377. We again place our stop loss 40 pips below the resistance at 1.3260. The next target price is at 1.3670, 20 pips below the historical resistance of 1.3690.
After a day, the price appears to have fallen back to the resistance level, which means a provisional loss of 77 pips. It is now important not to panic. It could be possible that we have misjudged the market, but it can also be the pullback. For this reason we placed our stop loss 40 pips below the resistance. So we just hold the position and wait. The exchange rate moves slightly below the resistance, but eventually continues its rise. Five days later, the target price of 1.3670 is reached and the position is automatically closed at the take profit, with a profit of 293 pips.
There is no reason not to repeat the same trick a third time. So after the new resistance of 1.3690 is broken, we open a position at the first positive candle above the resistance at 1.3737. Our stop loss we place at 1.3650. Unfortunately, after a half day the price dives to below the stop-loss level and the position is automatically closed with a loss of 87 pips. This is particularly unfortunate, because it appears that the price fell just a tiny bit further, to continue its upward trend afterwards.
Should we have placed the stop loss lower? That’s easy to say in retrospect, but the stop loss also protects you against large losses when the market is going in the wrong direction. Try to choose your stop loss so that you do not lose your position due to small fluctuations, while it still protects you against large losses. 40 pips below the resistance level seemed to be too tight in this case. But that is the risk associated with forex trading: even the best trader is not always right.
All in all it has been a successful trade (or actually three trades). We have made 479 pips in total. With a position size of 1 standard lot that is a profit of $ 4,790 in about 10 days!
Make money with the breakout strategy yourself?
You can test the strategies in this article yourself with the advanced forex trading software of Plus500. Plus500 offers a very nice trading platform and it also offers an unlimited demo account. The minimal deposit at Plus500 is just €100.
This article is part of the “Forex technical analysis strategies for advanced traders” series. Continue reading the next article “EMA crossover Forex strategy“