Trading Breakouts and Fakeouts

What are breakouts and how can I take advantage of them?


Unlike the breakouts you might have had as a teenager, a breakout in the trading world is a little different!

A breakout occurs when the price "breaks out" (get it?) of some kind of consolidation or trading range.

A breakout can also occur when a specific price level is breached such as support and resistance levels, pivot points, Fibonacci levels, etc.

With breakout trades, the goal is to enter the market right when the price makes a breakout and then continue to ride the trade until volatility dies down.

Volatility, Not Volume



You'll notice that unlike trading stocks or futures, there is no way for you to see the volume of trades made in the forex market.

With stock or future trades, volume is essential for making good breakout trades so not having this data available in the forex leaves us at a disadvantage.

Because of this disadvantage, we have to rely not only on good risk management, but also on certain criteria in order to position ourselves for a good potential breakout.

If there is large price movement within a short amount of time then volatility would be considered high.

On the other hand, if there is relatively little movement in a short period of time then volatility would be considered low.




While it's tempting to get in the market when it is moving faster than a speeding bullet, you will often find yourself more stressed and anxious; making bad decisions as your money goes in and then goes right back out.

This high volatility is what attracts a lot of traders, but it's this same volatility that kills a lot of them as well.

The goal here is to use volatility to your advantage.

Rather than following the herd and trying to jump in when the market is super volatile, it would be better to look currency pairs with volatility that is very low.

This way, you can position yourself and be ready for when a breakout occurs and volatility flies out the roof!

Market Environment

When two people go to war, the foolish man always rushes blindly into battle without a plan, much like a starving man at his favorite buffet spot.

The wise man, on the other hand, will always get a situation report first to know the surrounding conditions that could affect how the battle plays out.



Like in warfare, we must also get a situation report on the market we are trading. This means we need to know what kind of market environment we are actually in. Some traders cry saying that their system sucks.

Sometimes the system does in fact, suck. Other times, the system is potentially profitable, but it is being utilized in the wrong environment.

Seasoned traders try to figure out the appropriate strategy for the current market environment they are trading in.

Is it time to bust out those Fibs and look for retracements? Or are ranges holding?

Just as the coach comes up with different plays for particular situations or opponents, you should also be able to decide which strategy to use depending on market environment.

By knowing what market environment we are trading in, we can choose a trend-based strategy in a trending market or a range-bound strategy in a ranging market.

Are you worried about not getting to use your beastly range-bound strategy? How about your Bring-Home-Da-Bacon trend-based system?




Have no fear!

The forex market provides many trending and ranging opportunities across different time frames wherein these strategies can be implemented.

By knowing which strategies are appropriate, you will find it easier to figure out which indicators to pull out from your toolbox.

For instance, Fibs and trend lines are useful in trending markets while pivot points, support and resistance levels are helpful when the market is ranging.

Before spotting those opportunities, you have to be able to determine the market environment. The state of the market can be classified into three

Forex Pivot Points

Image via Wikipedia
Are you all excited? It's your last year in junior high before you head off to high school!

Professional traders and market makers use pivot points to identify potential support and resistance levels. Simply put, a pivot point and its support/resistance levels are areas at which the direction of price movement can possibly change.

The reason why pivot points are so enticing?

It's because they are OBJECTIVE.

Unlike some of the other indicators that we've taught you about already, there's no discretion involved.

In many ways, pivot points are very similar to Fibonacci levels. Because so many people are looking at those levels, they almost become self-fulfilling.

The major difference between the two is that with Fibonacci, there is still some subjectivity involved in picking Swing Highs and Swing Lows. With pivot points, traders typically use the same method for calculating them.

Many traders keep an eye on these levels and you should too.

Pivot points are especially useful to short-term traders who are looking to take advantage of small price movements. Just like normal support and resistance levels, traders can choose to trade the bounce or the break of these levels.

Range-bound traders use pivot points to identify reversal points. They see pivot points as areas where they can place their buy or sell orders.

Breakout traders use pivot points to recognize key levels that need to be broken for a move to be classified as a real deal breakout.

Here is an example of pivot points plotted on a 1-hour EUR/USD chart:



As you can see here, horizontal support and resistance levels are placed on your chart. And look - they're marked out nicely for you! How convenient is that?!

Support and Resistance

Support and resistance is one of the most widely used concepts in trading. Strangely enough, everyone seems to have their own idea on how you should measure support and resistance.

Let's take a look at the basics first.



Look at the diagram above. As you can see, this zigzag pattern is making its way up (bull market). When the market moves up and then pulls back, the highest point reached before it pulled back is now resistance.

As the market continues up again, the lowest point reached before it started back is now support. In this way resistance and support are continually formed as the market oscillates over time. The reverse is true for the downtrend.

Plotting Support and Resistance

One thing to remember is that support and resistance levels are not exact numbers.

Often times you will see a support or resistance level that appears broken, but soon after find out that the market was just testing it. With candlestick charts, these "tests" of support and resistance are usually represented by the candlestick shadows.



Notice how the shadows of the candles tested the 1.4700 support level. At those times it seemed like the market was "breaking" support. In hindsight we can see that the market was merely testing that level.




So how do we truly know if support and resistance was broken?

There is no definite answer to this question. Some argue that a support or resistance level is broken if the market can actually close past that level. However, you will find that this is not always the case.

Let's take our same example from above and see what happened when the price actually closed past the 1.4700 support level.



In this case, price had closed below the 1.4700 support level but ended up rising back up above it.

If you had believed that this was a real breakout and sold this pair, you would've been seriously hurtin'!

Looking at the chart now, you can visually see and come to the conclusion that the support was not actually broken; it is still very much intact and now even stronger.

To help you filter out these false breakouts, you should think of support and resistance more of as "zones" rather than concrete numbers.

One way to help you find these zones is to plot support and resistance on a line chart rather than a candlestick chart. The reason is that line charts only show you the closing price while candlesticks add the extreme highs and lows to the picture.

These highs and lows can be misleading because often times they are just the "knee-jerk" reactions of the market. It's like when someone is doing something really strange, but when asked about it, he or she simply replies, "Sorry, it's just a reflex."

When plotting support and resistance, you don't want the reflexes of the market. You only want to plot its intentional movements.

Looking at the line chart, you want to plot your support and resistance lines around areas where you can see the price forming several peaks or valleys.



Other interesting tidbits about support and resistance:

When the price passes through resistance, that resistance could potentially become support.
The more often price tests a level of resistance or support without breaking it, the stronger the area of resistance or support is.
When a support or resistance level breaks, the strength of the follow-through move depends on how strongly the broken support or resistance had been holding.



With a little practice, you'll be able to spot potential support and resistance areas easily. In the next lesson, we'll teach you how to trade diagonal support and resistance lines, otherwise known as trend lines.