Trading Breakouts

The first thing we need to talk about is the two different types of breakouts. There are two main categories than any breakout can fall into. There are continuation breakouts and reversal breakouts. Let’stake a look at both on the charts so that you have a clear understanding
of each type.


Trading Breakouts
As the name suggests a continuation breakout is simply a breakout that occurs as a continuation of the underlying trend. As an example, if you look at the chart above the currency pair is currently in an uptrend.However, a period of consolidation has occurred and the price then broke-out above the consolidation point to continue on with the trend. A continuation breakout is generally shown by a period of fast price movement after a slight reversal or consolidation of price against the trend.REVERSAL BREAKOUTS
Trading Breakouts
Exactly the opposite of a continuation breakout is a reversal breakout. This type of breakout occurs against the underlying trend and is usually the indication that a reversal in the trend itself is occurring. Often these types of breakouts will be seen on the charts by patterns like flags or pennants forming and then the breakout itself occurring. As a general rule the reversal breakouts are the most profitable to trade as breakouts within the current trend generally don’t carry a lot of steam and they can be traded just as easily by riding the trend.FALSE BREAKOUTS
Trading Breakouts
GETTING TECHNICAL ON BREAKOUTSOne of the reason that many traders fail to trade the breakouts profitably is simply because they don’t take the time to measure the strength of the price movements. Luckily, this isn’t really a difficult thing to do. In fact you only need an understanding of two indicators to properly gauge the strength of a breakout. To gauge the right times to trade a breakout we’ll use the MACD (Moving Average Convergence Divergence) indication, and we’ll also use the RSI (Relative Strength Index) indicator.A LOOK AT MACD
Trading Breakouts
To learn how to use MACD to properly trade breakouts let’s talk about the indicator itself. In it’s normal use (12, 26, 9) the MACD indicator actually contains three different types of signals. It has:
1. A MACD line which is the difference between the 12 period and 26 period EMA’s
2. A 9 period EMA used as a signal line
3. A histogram which represents the difference between the MACD line and the signal line.
If you look closely at the signals you can get from the MACD you’ll begin to notice a few things. First when the MACD line rises above the signal line the histogram also rises above the zero line. As the price movement accelerates the histogram grows and the space between the MACD line and the signal line also grows. As the momentum of the price slows the histogram falls closer to the zero line, the two lines also grow closer together and eventually cross over (assuming the price has changed direction). You’ll also notice that the sharper that crossover is, the faster the price was moving when the MACD and signal lines crossed. The same scenario is true for downward price movement but the signals are opposite (the histogram is below zero and the MACD line is below the signal line).
In other words the MACD is very good at detecting price moment, andwe can use it’s signals to help us gauge when a reversal breakout is about to occur.
The divergence of the MACD can be a good indicator that a reversal is about to occur. If you see the price making higher highs and at the same time the MACD is making lower lows this tells us that a reversal is likely to occur.
When you see a potential reversal breakout scenario on the charts you should always check what the MACD is doing. If the histogram is doing the opposite of what the price is, it’s a good confirmation that a real reversal breakout is about to occur.
Trading Breakouts
RSIAnother indicator that can be useful to gauge momentum and confirm when a breakout is about to occur is the RSI (Relative Strength Index). This indicator is often used to indicate overbought and oversold condition, but for our purposes we don’t want to use it that way.
Trading Breakouts
Much like the MACD, before a breakout occurs you’ll often see a divergence between the price on the charts and the line on the RSI. Looking at the chart above the price is on it’s way up, and the peaks of the RSI create line down. Shortly after that occurred a breakout did
occur, which reversed a long standing up trend. Checking the RSI, in this fashion, can be useful to confirm your signals when a breakout opportunity is showing on the charts. It will help you to avoid the false breakout signals.
FINDING THE RIGHT OPPORTUNITIESTrading breakouts is impossible if you don’t know how to find the right opportunities. There are two easy ways to find when breakouts may occur. You can use channels on the charts or look for the right patterns. In either case you can find the opportunity, confirm it with the technical indicators we just covered, and then trade breakouts profitably. Let’s cover how you can use either method to find trading opportunities that will allow you to take advantage of the large price movements with a breakout.CHANNELSWhen looking for opportunities for breakouts one of the easiest ways to do so is by using trend lines. In this case though we aren’t going to use a single trend line to gauge the opportunity; rather we’ll use trend lines drawn as channels to gauge when to trade.
Trading Breakouts
Channels are created by simply drawing two trend lines instead of 1. You draw a trend line both above and below the price movements on the chart rather than using one trend line to trade. Here’s what channels look like in a down trend.
On the chart above you can see the price mostly moves between the two channel lines in the current downtrend. The trend itself is a long-term trend and it’s beginning to run out of steam.
There are two breakouts on the chart shown. There is a continuation breakout and a reversal breakout. When trading breakouts you should avoid the continuation breakouts. They tend to be short lived. In this case you’d just trade the breakout where the price reversed above the
top trend line. Let’s take a look at an example of a breakout opportunity in an uptrend.
On the following page the chart includes two trend lines to form a channel. At the top of the channel a reversal breakout has occurred. In this case we left the RSI on the chart to show that a divergence has occurred just before the breakout which confirms for us that this is a
good opportunity to trade the breakout.
Trading Breakouts
CHART PATTERNSAnother way to find opportunities for breakouts is by looking for patterns on the charts. There are a few different patterns that may form before a breakout occurs. These include:FlagsPennantsHead & ShouldersDouble Tops or Double BottomsDiamondsOthers
We’ve talked about head and shoulders and double tops/bottoms earlier in the this guide so let’s cover a couple of the others. Two of the most common patterns that you’ll find forming before a breakout occurs are flags and pennants.
A pennant is simply a triangle shape formed out of bars or candles and it’s really just a period of consolidation in price before a breakout occurs. Looking at the same example we used for the up trend previously, a pennant formed before the reversal breakout occurred.
Trading Breakouts
The other common pattern that you’ll see before a breakout is a flag. This is simply a rectangular channel that forms before either a continuation breakout or a reversal breakout occurs. Most often you’ll see flags form before a continuation breakout, but they can also
indicator a reversal so you should watch for these opportunities as well. On the chart below a flag formed, a false breakout occurred, and then a pennant formed before the actual continuation happened.
Trading Breakouts Pennant
AVOID THE FALSE BREAKOUT (MAKING THE TRADE)With some knowledge about the types of breakouts, how to look for opportunities, and the indicators that can be used to confirm them - let’s cover making the trade. Really at this point our main goal is simply to avoid the false breakouts and to capitalize on the real reversal breakouts to make some big profits fast! One of the easiest ways to trade the breakout profitably more often is to not take the trade right away. Just because you see a bar breaking
through your trendline, doesn’t mean it will continue that way. Instead of just jumping in blindly wait until a bar closes at least 10 pips on the other side of your trend line. Once a bar actually closes on the other side of the line you can be reasonably sure that the breakout
reversal will occur.
Trading Breakouts
After the price has closed on the other side of the line you can place
your order at least 10 pips above or below that point (depending on what direction your trading). Once the trade is entered you should set your stop just back of the trend
line at the point of entry. Usually 15 - 30 pips back of the line is acceptable. That way you’re protected should the breakout end up being false, but you’re also allowing yourself enough breathing room so that you don’t stop out before the breakout gains momentum.
When you’re in the trade with a breakout I don’t actually suggest you use take profits. Rather you should trail your stop at the level it was when you entered the trade and wait until things slow down. Some breakouts will move quite quickly and riding one out can allow you to
make a few hundred pips in a short time if the market conditions areright. You should trail your stop to protect your profits, but allow the breakout to run for a while before deciding to exit the trade.
CONCLUSIONYou now have three separate systems that work well to trade. All of them can be profitable if you learn them well. Even just learning one system will take you into a profitable future in Forex. However, it’s those among you who learn to trade all three that will stand to profit the
Most. By riding the trends when they are occurring you can earn big profits over time. Trading the breakout fades at the same time will allow you to earn big profits, in a short period, of time with smaller trades while your trend riding trade lasts for days. And finally by trading the breakouts you can catch the trends on the reversal and earn big profits while you
wait for the new trend to establish itself. Combining all three trading methods given in this guide can earn you big money with your trades. The key to success here is to learn the systems, trust the systems, and always use a good money management system when you trade. If you can do that then you really won’t need any other trading systems throughout your Forex career.

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