A Definitive Guide to Breakout Trading

Breakout trading is quite an interesting feature to the traders who love to go after quick and obvious profitable trades. Although, this quick profit trading approach involves a significant level of quick losses as well. A trader needs to be able to filter trade setups with better winning probabilities on a consistent basis to achieve long-term success in breakout trading. There are also some other factors you need to know before adding this “tempting” trading strategy to your trading arsenal, which we’ll discuss throughout this article.

What is a Breakout?

A breakout happens when price moves out of a certain support or resistance level and tends to “showdown” a one direction movement with an increasing level of volume and volatility of the market. Breakout takes place usually after price gets collapsed in a shorter range or sideways. The high of the range is considered as the resistance and the low as support of such particular setups of the market. The basic concept is, go long (buy) if the resistance is broken and go short (sell) when the price drops below the support level. Many traders set pending orders just outside the support/resistance areas so that they never miss a breakout move.

There are two different ways to attempt the breakout trading:

  • Aggressive Approach
  • Conservative Approach

1. Aggressive Approach

Breakout
Breakout

Aggressive traders execute their plan of actions or trades in a very straightforward manner. They take less than a second to pull the trigger when price breaks out of their predetermined support or resistance levels.

This kind of trading approach involves a lot of excitement like being able to board on a running train which is fast and moving towards your desired destination. The scenario changes if the breakout ends as a “false break”. A false break is when price momentarily moves above or below the key support or resistance level and then retreats back to the side from where the breakout movement was initiated. This is the most frustrating situation for a breakout trader who aggressively triggers their trade entries at the first stage of the breakout and then, price starts to move opposite to their trade direction by plotting a false break.

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False Breakout
False Breakout

The above EURUSD chart is an example of a breakout move that turned into the false break at the end. When price broke and went above the resistance (R1), aggressive traders may enter long anticipating the price is about to hit the next resistance level as their target. In spite of that, price returned back below the resistance area just after the breakout by plotting a false break instead and then kept moving further down below the current support (S1) level. So, besides enjoying quick straightforward profitable trades, an aggressive trader also has to face unexpected false break challenges at the market.

2. Conservative Approach

After a breakout, many times it has been observed that, price retreats and retests the currently broken support/ or resistance level before making the final move towards the initial breakout direction. Conservative traders don’t place their trades at the first stage of any breakout. Instead, they wait for more confirmation and make the market entry only if price bounces back to the breakout direction from the key market level. Let’s have a look at the chart example below:

Support and Resistance
Support and Resistance

This is what happened here:

  1. Price breaks out of the resistance level
  2. Retraces back to the resistance
  3. Uses the resistance as a support level and re-joins the bullish rally

Conservative traders will enter long (buy) from the green rectangle area where the price gets rejected from the support level for a number of times and generates the confirmation of a possible bullish move. It is true that, as a conservative trader, you may often miss a trade if the price doesn’t retrace back to the current key market level. Nevertheless, the conservative approach carries a better probability of success than the aggressive tradings.

When to exit a breakout entry?

Closing the trade prematurely at the half-way is a common mistake that most of the newbie traders do. Such bad habits do no let you earn more than you risk for a trade. In terms of forex trading, an exit is more important than a trade entry, because your profit or loss straightly depends on where you exit the trade. You really need to set a target that helps you to avoid closing your entries prematurely, which mostly happens in breakout trading because of higher excitements. The basic rule is, to set a standard amount of profit/rewards target against each dollar you risk at the market. We recommend, breakout traders to target double rewards compared to their budgeted loss for each and every particular trade. Many professional traders use forthcoming support/resistance or key market levels as their exit points.

A Stop Loss is a Must

Stop loss works as a safeguard of your trading account only when you know how to place it properly while trading.  Placing a narrow or tight stop loss in a highly volatile market can be another reason for getting out of the trade prematurely with losses. A wider stop loss lets the trade to breath more to survive in the long -run. Let’s have a look at an example:

Stop loss
Stop loss

This hourly EURUSD chart represents a buy setup based on a bullish breakout at the resistance. If you’d put a tight stop loss limit in between the support or resistance level (SL1), it would easily get hit by turning your trade as a failed entry right before the final take off. On the other hand, a wider stop loss placed below the support level (SL2) looks much safer. Even though price moved opposite to the trade direction for a while at the early stage, it turned as a profitable trade at the end! So, the plan can be summarized as, if you buy above the resistance, place the stop loss below the current support. Contrarily, put the stop loss above the current resistance area while selling below the support level.

The Bottom Line

There may be a debate about which method is the best to execute the breakout trades. Aggressive traders miss the trade signals less but often be challenged by false breaks. On the other hand, conservative traders miss a lot of trade opportunities while filtering the breakout signals. We believe, losing an opportunity is better than making a losing entry. So, newbie traders can start with the conservative approach while trading the breakouts at the market. A successful career as a breakout trader requires plenty of self-confidence, strict discipline, and patience.

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I have been actively trading stocks and currencies since April 2012. Besides trading with my personal money I am a technical analyst in a mutual fund which has Rs. 1 billion in assets under management. At my leisure, I love attending live music, traveling, and partying with friends.

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