Have you ever seen a price of a particular currency pair “break” a support line or a resistance line? –And when it does, it goes down (or up) by 10, 20 even 40 pips in a flash of an eye. If you have experienced that, then you know what a breakout is. In this article I will explain in my own view how and why these breakouts occur, what to look out for when trading them and my no non-sense advice on what to do.
I spent most of my trading career chasing after breakouts because like most Forex traders, I believed that that is where you can make money really fast. Of course the reality of it is, and as painful as it is to admit, chasing after breakouts makes you lose money really fast as well. Especially if you don’t know what you are doing. Trading a breakout is a lot riskier than if you were to trade the range.
First of all, your risk to reward ratio is no where near the ideal and in most cases it is the opposite. The ideal Risk to reward ratio would be 1 is to 2 meaning risk only a dollar for the potential of gaining 2 dollars on every trade. Breakout trading demands the opposite, risk 2 dollars for every 1 dollar of gain. Highly illogical, but very much done even by the most veteran of traders because of the strong temptation of fast money in an already fast market.
Another main difference in trading breakouts is in the way you would enter and exit. In Range trading, you simply follow the mantra “Buy low, Sell High” or “Sell High, Buy Low”. In Breakout trading, the mantra is: “Buy High, Sell Higher”, or “Sell Low, Buy lower”.
Momentum trading is another word for breakout trading.
Ever catch a strong News release and see the price skyrocket into the heavens and something in your head tells you, “get in now the boat is leaving, you don’t want to get left behind” Those situations are hard to ignore and even harder to resist, so what do you do? — Buy at a high price in the hopes of selling it off when it reaches a higher price. It works from time to time, problem is, it happens approximately about 20% of the time only. So what are the odds of you getting stopped out? Plenty.
How do breakouts happen?
Well, it all begins when traders such as you and me place stop-loss orders. (Before I continue, I am a very strong advocate of always placing stops on “directional” trades. Please note, that what you will read may cause you to stop using stop orders, that is not my intention, I still place stop orders on all my directional trades and I strongly recommend that you should too.) Okay going back, when we place stop-loss orders remember that these orders are to get you out when the market goes against you. So if you buy something and place a stop-loss order on that trade, when your stop is hit, you exit at a loss by “Selling out.”
So let me give a scenario, let’s say you buy EUR/USD at say 1.4500 then you place a 20 pip stop loss order then that would be Stop: 1.4480. If the market went down to 1.4480, you would sell off your trade accepting a loss of 20 pips and you are out of the trade.
Now what if your trading volume for you alone would be US$100,000 (This is the leveraged amount that the broker lets you trade with) so automatically when your stop was hit, $100,000 of selling occurred.
Now what if there were about 3,000 more traders like you who were stopped out at 1.4480, and let’s say their trading volume was about the same, let’s multiply the trading volume altogether 3,000 traders x $100,000 = $300,000,000 That’s a 300 million dollar sell off, do you think if that happened, the price would dip by about 10 pips or so? probably. The point is, when stops are hit, there is an automatic sell off which causes a knee jerk reaction of the price to spike.
Now let’s tak about support lines. The support line is where we project where people are buying correct? This is why bounces occur. So if traders are buying around this area, where would their stops be? It would be about 10 or more pips below this support line.
So let’s say that there are about 30,000 bulls (traders who buy) around the support line, and all of them had about a 10 to 20 pips stop loss, what would happen if the market “broke through” the support line and triggered their stops? Bingo, a huge sell off that would cause the price to spike down by about 10, 20, 40 or even more pips. This is why breakouts occur.
Why Do breakouts Happen?
For me it’s quite simple, Breakouts happen when there is a shift in power from Bulls to Bears and Bears to Bulls. In other words, when Sellers have a greater force (volume) compared to the buyers, the support line will be broken and the stops of the bulls will be triggered usually causing a shift in the trend.
In this case from an uptrend to a downtrend. Now when the Buyers have a greater force (volume) compared to the sellers, the resistance line (where traders are selling / shorting) will be broken and the stops of the bears will be hit causing another shift in the trend. In this case from a downtrend to an uptrend.
Why will there be a shift in power? Many, many reasons that economists, fundamentalists, technical analysts can debate about all day long. Bottom line A breakout happens because change has happened somewhere and on something out in the financial world.
What to do when there is a breakout?
My advice, if you are not seasoned enough to spot breakouts, I suggest that you do not trade it at all as the odds are pretty much not in your favor. However if you want to experiment on your own, I suggest you do what I do – HUNT for the Big Players STOP orders. Now stop hunting is not an exact science, I’ve been wrong more times than I’ve been right. It’s dangerous and riskier than Range trading, but it sure is fun.
Stop hunting is a bit more complicated and would require a lot more explanation than this already long article of mine so let me leave it at this. Learn how to draw support and resistance lines, then follow the behavior of the market weaving up and down this channel. If the market is trending up in a very strong way, most likely there are a lot of stops just below the trend support line that you just drew.
Why? Always remember this wise saying, The Higher the Mountain, The deeper the Valley. Learn how to place Sell entry orders at this area (it’s like playing in คาสิโนออนไลน์ ) if you placed your Sell entry order at the right place, Bingo, that’s an easy 10 to 20 pips for you at least.
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