What is a 'Breakout'?

Breakouts - Major, Minor, and Reactive

Breakouts are classified by various behavioral characteristics, as well as by the circumstances or "context" surrounding the breakout. For example a breakout is often considered "major" if it moves above a specific recent high and continues on an extended trajectory sometimes with multiple trending "legs" of upward movement before reversal (40-100 pips). Breakouts are also referred to as major if the upward movement is beyond a point not attained for an extended period of time, signaling the possibility of further upward movement even if not immediately. In effect, a precedent for further upward movement is established.

Minor breakouts often occur when the price of a currency pair overcomes a specific point of resistance, but fails to continue for more than a relatively short trajectory (10-15 pips). The price will sometimes break a point of resistance, but reverse almost immediately barely surpassing the resistance, in which case it is considered a failed breakout. Minor breakouts and failed breakouts are often followed by more extended breakouts, either shortly thereafter or many hours later. The key is to observe whether or not the price remains in the breakout zone after breakout failure, and the tenacity with which it remains in the zone.

A "reactive" breakout occurs in the form a sudden and often extended move upward to traverse and compensate for a recent steep decline in price of the"knee-jerk" variety. Such a sudden drop in price is characterized by a near vertical appearance on the 5-minute chart. Before the breakout, the price will often make it's way to the foot of the near vertical drop, and after minor hesitation suddenly move higher to traverse almost the entire course of the recent drop though it will sometimes stall at one of the 3 Fibonacci resistance points of 38.2%, 50% or 61.8% of the recent drop. The reactive breakout can be a powerful movement, often resulting in a fast scalp of between 15 and 30 pips. The resulting configuration on the chart will be 2 near parallel lines representing action and reaction. Reactive breakouts often take place within 12 hours of the sudden drop in price and can be gauged nicely on the 5-minute chart for entry and exit.

Early Breakout Indicators

Breakouts take place in the direction of the longer-term (daily, weekly) trend or may take place counter to the prevailing trend. It may be said that the earliest breakout indicator is simply the movement of the price of a currency pair toward a point of recent resistance. This may come, for example, in the form of a trendline break or as the price overcomes minor resistance. If the price makes its way to a breakout"zone" , i.e., within 5-10 pips of a recent high point and remains there with little reversal this is an indicator of strength, and may portend a breakout after a period of"basing" in the breakout zone. The sudden, abrupt movement of the price to a breakout zone is usually a stronger sign that the price may be preparing to move higher with authority. The price of currency pair may also base in a channel of varying size (usually 10-20 pips wide), sometimes for many hours. If the price drops well below the channel, but quickly"rebels" to return to the breakout zone, this is also an indication that there is appreciable interest, and that a breakout could be coming, though perhaps not immediately. Often, the price will"stall" stubbornly within the breakout zone as it waits for a "green light" in the form of news that is relevant to the currency pair. A currency pair may also await the breakdown through support of a pair that moves inversely, as is the case in the correlation between the eur/usd and the usd/chf. For example a breakdown in the usd/chf could signal a breakout of the eur/usd, just as the refusal of the usd/chf to break down through a support point could foretell a failure to breakout on the part of the eur/usd.

Indicators of Imminent Breakout

Often after much hesitation in the breakout zone, the price of a currency pair will begin to exhibit behavior indicating the breakout is imminent. The first indicator of this is the sudden"positioning" of the price at the top of the breakout zone, often within 2-3 pips of the recent high in effect "tightening" the breakout zone to just a few pips. At this point the number of changes in price or "ticks" exhibited by the currency pair often increases dramatically, as a battle of nerves takes place between bulls convinced that a breakout is about to take place and bears holding out hope of a breakout failure. We can feel the tension in the air as the price moves up and down within this tiny zone. This "edgy" behavior is a strong indication that a breakout attempt is about to take place, often within minutes. Sometimes the price will suddenly remain still for a longer time (10-20 seconds) just below the high before the breakout is finally attempted.

The most powerful breakouts result from the combined enthusiasm of "new longs" taking positions and shorts "capitulating" by covering their positions with equal enthusiasm. But the shorts don't always lose, as sometimes breakouts will fail. It is important, however, for traders to recognize the signs of a breakout, as sooner or later it will take place.

Playing the Forex Breakout

Breakouts should be played with a well thought out strategy that will enable benefiting from a good breakout, while avoiding substantial loss in the event of a breakout failure or sudden reversal. The market "context" surrounding the price movement should be carefully considered when trading breakouts. For example if a strong uptrend is in place, and the price has been basing stubbornly in a breakout zone, the odds of a breakout are good provided there are no significant points of resistance nearby, such as a "strong Fib" . On the other hand, if several breakout legs have already played out, there is a greater possibility of breakout failure. The time of day is also important to consider in playing breakouts, as periods of low volume for a particular currency pair may cause a breakout to fail. Position size is a crucial element of risk management when playing the Forex break, as are placing stops. The market psychology of Forex breakouts is such that if there is repeated failure, a sudden"angry" reversal can take place. This is a highly treacherous characteristic of failed breakouts, and occurs when a significant number of players become convinced that the breakout will not succeed and therefore exit their positions and /or substantial short positions are taken driving the price lower. It is here that getting caught at the "top" with a large position size can prove very painful unless a relatively tight stop is in place.

When playing the breakout, the next points of resistance should be anticipated on the charts in order to predict with reasonable probability how long the break trajectory might be. Resistance, especially Fibonacci resistance points and regions of congestion should be anticipated well in advance of the actual break. If momentum appears strong in a breakout, traders may choose to remain long and seek further upward movement. More conservative players may choose to"scale out" of their positions or, perhaps exit completely if an important resistance point is reached and the price stalls. Breakouts have an amazing range of travel in terms of trajectory. Some breakouts move only 20-30 pips higher before a significant reversal. Others can travel 300-400 pips in several successive "legs", continuing to climb and attaining new highs even after substantial but brief pullbacks. It is in such cases that traders may "manage" their positions, making partial exits to avoid riding out strong pullbacks while staying in the trade with more modest positions. Other breakouts will have long upward trajectories in stair-step fashion without appreciable pullbacks, with upward movement only detaining at various 'bases' before continuing higher.

If a trader misses a breakout it is important to accept this and rather than chase the breakout, patiently wait for a pullback in order to enter at an advantageous price point in terms of risk/reward. This is since strong breakouts often have abrupt reversals whether they continue higher afterwards or begin trending down in earnest. Positioning for a breakout just before a news announcement carries substantial risk and is not generally recommended as good trading practice. This is since short-term trends, however strong, can see quick reversal if news is interpreted as negative for whatever reason.

Conclusion 

Breakouts are only one part of the Forex trading 'universe', albeit an important part. Many traders have their own tell tale signs and signals of coming breakouts. Like many Forex topics, breakouts can be complex and require experience to play profitably and consistently. But it helps to have an idea of the behavior exhibited by currency pairs before and during breakouts, as well as a sound breakout trading strategy that includes risk management. Breakouts are an illusive beast whether we stalk them for a modest scalp or for a fabulous"run" of a few hundred pips. And of course these ideas all pertain to upside breaks. Naturally there is the equally fascinating topic of breaks to the downside. But that topic is for another day.

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