Forex Breakout Confirmation Strategy
This forex strategy tries to exploit the times when the market is not trending. In essence, it rests on the statistics which show that the Forex market is trading in a range of about 70% of the time and it’s trending only about 30% of the time.
Since price fluctuations are very unpredictable and irregular while inside of a ranging formation, it’s better and wiser to trade on a breakout of that ranging formation instead of trading it.
That’s why a specific set of conditions must be met in order to increase the chances of making a profitable trade.
Conditions of the Forex Breakout Confirmation Strategy:
- Obviously, there must exist a range for the price to breakout out of. Now, for the purpose of this strategy, a range is not only the horizontal case but also a channel sloped upwards or downwards, as in a trend. In fact, a channel in a horizontal position is the classical form of a trading range.
- Next, before we consider entering a trade we need to have the price breakout out of the range or the channel.
- Finally, to initiate a trade we need to have a confirmation of the breakout. This confirmation massively increases the probabilities that the breakout is true and hence the trade will be profitable. Without confirmation, there is no trading signal as per this strategy.
Note: The mechanics of this strategy can be also successfully used in determining true breakouts in single trendlines (without a range or a channel). However, a break of a simple trendline has proven to be less significant than the breakout of a channel or a range. Therefore, trendlines are not included as a condition in this strategy.
- Find a well-established channel or range on the chart. A channel is defined as a period of time when price action is trading within two parallel trendlines on the chart and is prominently touching those two trendlines during this period. For this strategy, a minimum of three touches is required on each trendline, as in the example below on the AUDUSD 4h chart. However, experience tells us that the more times the trendlines are touched the more significant the channel becomes. This in turn later makes the breakout much more significant as well.
- Wait for price to clearly break the range with a close outside of the range.
Note here, that for a range you can trade the breakout in both directions either short or long depending on which way it breaks out. However, it’s different from channels because they often represent trends. So, the rules here are: you can trade an upward channel breakout only to the downside, and a downward channel breakout is only valid to the upside. When the opposite happens it can actually be a trap (often referred to as a bubble) and price quickly reverses.
- Wait for a pullback in price to retest the broken border (trendline) of the range.
- Enter after a successful retest of the trend line and a rejection of a move back inside the channel. Successful retest simply means prices have reversed from the trendline in the direction of the breakout. Usually, this occurs with some reversal candlestick pattern, like candles with long wicks (Pin Bar). This situation is shown in the example below at the entry point.
Initial Stop Loss Placement:
One of the best parts of this strategy is that it usually provides very tight stops and big profit potentials.
The stop loss should be placed right behind the retest of the broken trendline. That is:
- above the retested highs in a downside breakout (look at AUDUSD chart example above); and
- below the retested lows in an upside range breakout (look at USDJPY chart example below)
Targets and Take Profit Rules:
For a horizontal range
- Measure the height of the range and project it from the point of breakout.4 possible targets can be calculated in this manner:1st target – 0.5x the height of the range2nd target (most probable outcome) – 1x the height of the range
3rd target – 1.5x the height of the range
4th target – 2x the height of the range
It’s best to take profit on part of the position at each of these targets or use a trailing stop after the first 2 targets are reached.
For a sloping channel
- Measuring and projecting the height of the channel is not as reliable as with the horizontal range. That’s why it’s better to target major support or resistance levels instead. Zoom out on a timeframe that is 1 degree greater than the setup chart. Look for past support or resistance levels beyond the breakout and use those as targets.If no prominent support or resistance levels are present, use Fibonacci retracements and extensions to determine important price levels.
Note: If the appropriate target level (support or resistance) is too close to the entry point then trades should not be taken.