As a forex trader, the most common phrase is, “The trend is your friend!” Does it mean that the only tradable strategy is trend following? Absolutely not! If mastered, breaking out trading is another excellent trading strategy that can make you part of the coveted group that makes profits consistently from the forex markets.
What is a breakout?
The forex market has significant price points that traders always take into consideration. They are psychological price points more than anything else. The four psychological levels traded by traders are;
- Resistance Level
- Support Level
- Fibonacci Retracement Levels
- Pivot Points
The forex market is driven by demand and supply forces, just like any other market. When the supply in the market exceeds the demand, the lure of that asset wanes and holders are in a hurry to take it off their hands. It is a phenomenon known as selling pressure. The highest price value attained by an asset before selling pressure exceeds buying pressure forcing prices down is referred to as a price resistance level.
Flip the coin on the resistance level and what you get is a support level. When the demand in the market exceeds the supply, the lure of an asset skyrocket driven by the increased price value of that asset. Every investor wants to hold this asset with the dream of cashing later at a profit. It is a phenomenon known as buying pressure. The lowest price value attained by an investment before buying pressure exceeds selling pressure buoying prices up is referred to as a price support level.
Fibonacci Retracement Levels
The study that has gone into the Fibonacci numbers is quite extensive and would require a full thesis. Traders’ interest is in Fibonacci retracement and extension numbers. Leonardo Fibonacci, an Italian Mathematician, discovered a series of numbers that apply to everything in the universe in the form of ratios. It is complex a formula that adds two consecutive numbers to get the third number on the series. Don’t worry your pretty head about the calculations; all trading platforms come with the Fibonacci indicator as a default trading indicator.
The numbers significant to trading are:
- Fibonacci Retracement Levels; 0.236, 0.382, 0.618, 0.764.
- Fibonacci Extension Levels; 0, 0.382, 0.618, 1.000, 1.382, 1.618.
More on this as we discuss the Fibonacci indicator.
Pivot points in most cases are mentioned in the same breath as support and resistance points. They have calculated price points that help identify when the market price sentiment is either bullish or bearish. They are especially popular among intraday traders.
THE BEST BREAKOUT INDICATORS
It is crystal clear that these psychological price points play a significant role in how the forex market is traded. Unlike trend trading, these price points are not easily distinguishable. How then do you take advantage of trading opportunities around these points? This is a guide on the best trading indicators that help identify when prices breach these significant price levels providing profitable trading opportunities.
Support and Resistance Indicator
We have already defined what support and resistance levels are. How do you use the support and resistance level to take advantage of trading opportunities when price breaks either above or below the resistance and support levels, respectively? First, understand that the more a support or resistance level is tested, the weaker it becomes.
Different resistance and support levels have differing significance hence the classification into minor and major supports. The indicator itself classifies the levels when attached to a trading chart. When prices break a resistance level, form a high and retraces and then breaks the high created, the integrity of that resistance level is compromised, flipping it to a support level. Go long in such a scenario. When prices break a support level, form a new low, retraces and then breaks the low created, the integrity of that support level is compromised, flipping it to a resistance level. Go short in such a scenario.
Pivot Point Indicator
More than 80% of the time the market prices oscillate between the R3 and S3 pivot points. All the day traders keenly observe when the market prices test these two points. Suppose the prices test and break these pivot points, activate a trade in the market’s direction on the break of the close of the signal candle, price candle that breaches the S3 or R3.
The Fibonacci indicator is used to identify price support and resistance areas. After a significant price movement, the assumption is that the market must retrace before prices rally and continue in the original trend direction. While the retracement levels identify supports and resistances, the extension levels act as take profit levels.
The first thing to know before using this indicator to take advantage of breakouts is how to draw it on a chart. You must be able to identify swing highs and swing lows. In a bearish market, click on a swing high and drag the cursor to the most recent swing low. In a bullish market, click on the swing low and drag the cursor to the most recent swing high. Once this occurs, the indicator automatically displays the Fibonacci levels.
By identifying significant supports and resistance levels, the Fibonacci levels act as probable points for breakout trading. A breached level provides a trading opportunity in that direction up to the testing of the next level. A trader is activated to break the high or low of the first candle to breach a Fibonacci level for either long or short entry, respectively. Despite the application of Fibonacci numbers in various disciplines, they are not the financial markets’ holy grail. It is therefore prudent to trade their breakout but in the direction of the general market trend direction. It is also advisable to couple it with other trading indicators to make up a more robust trading strategy.
Trend lines are traditionally used to identify a trend and then take advantage of the existing movement. To determine when the market is bullish, join two successive higher lows. On the other hand, you identify a bearish trend by joining two consecutive lower highs. How do you trade a breakout using such a tool?
When a trend retraces and tests the trend line, there are to probable scenarios;
- Either the trend line maintains its integrity and prices bounce back,
- The trend line is breached, and the market exhibits a new trend.
Can you take advantage of a compromised trend line and make profits. Absolutely! To go short on a broken bullish trend line, wait for the market to retrace towards the trend line, and once the new lower high is broke, activate a short position. To go long on a broken, bearish trend line, wait for the market to retrace towards the trend line, and once the new higher high is broken, activate a long position.
The other trend line breakout trading strategy is to draw a trend line on different timeframes. At the intersection point between any two trend lines, activate a position in the direction of the broken trend line. This strategy is for the risk-takers.
Moving Average Convergence Divergence
The MACD, moving average convergence divergence, is a trend-following oscillator using moving averages as its building blocks. Making up its DNA is a slow and fast EMA, exponential moving average. The difference between these two exponential moving averages is what is plotted and is known as the MACD. Coupled with the MACD line is a signal line.
The signal line which is another EMA with settings based on the MACD line. The standard period of the signal line is 9. The signal and MACD lines oscillate around a 0 level.
The MACD alone cannot act as a breakout indicator. However, when paired with either a trend line of price channels, it confirms whether the breakout is just a minor retracement or the market momentum is enough for the price to breakout. The divergence between the signal line and the MACD line gives insight into the market momentum, the more the divergence, the more the momentum. A break of prices on any other indicator used to identify the significant price points coupled with diverged MACD points to an excellent breakout position.
There is o denying that things are easier for you in the financial markets when you trade with the trend. As such, the breakout indicators discussed herein should be first and foremost used to take advantage of opportunities in the prevailing trend direction. For the risk-takers, trading opportunities counter to the market trend might also prove profitable but require close monitoring.
All of the trading indicators above are the best in breakout trading because they identify significant price points that every trader with some market experience is monitoring. Besides, most experienced traders swear to their success. However, the financial markets are risky, and robust trading strategies need excellent money management rules to succeed.
Have fun as you grow your account using the breakout trading.