You may have encountered a breakout when trading in the UK foreign exchange (forex) market. But what exactly is a breakout in forex trading, how do they occur, and what should one do when encountering a breakout?
A trading breakout is when the price of a currency pair moves outside of a defined support or resistance level. This movement can happen for various reasons, but most often, it is due to an unexpected news event or a change in market sentiment.
Breakouts can be either bullish or bearish. A bullish breakout occurs when the price breaks out above resistance and continues to move higher. A bearish breakout happens when the price breaks out below support and continues to move lower.
How to trade breakouts
One way to trade breakouts is to wait for the price to close outside of the support or resistance level, known as a breakout candle. Once this occurs, you can enter a trade in the breakout direction.
Another way to trade breakouts is to use pending orders. You would place a buy order above resistance or a sell order below support with this method. Your order will be executed when the price breaks out and moves in your favour.
Indicators that traders can use to trade breakouts
Traders can use several indicators to trade breakouts. These include the Bollinger Bands, MACD, and RSI.
The Bollinger Bands indicator is composed of an upper line and a lower line. These lines are typically two standard deviations away from the 20-period moving average. Traders can use the Bollinger Bands to trade breakouts. It is considered a bullish breakout when the price breaks out above the upper line. Likewise, it is considered a bearish breakout when the price breaks out below the lower line.
The MACD indicator comprises two lines: a signal line and a histogram. The signal line is typically nine periods away from the 26-period EMA. The histogram measures the difference between these two lines.
When the MACD histogram is positive, the signal line is above the 26-period EMA and is considered a bullish signal. Conversely, when the MACD histogram is negative, the signal line is below the 26-period EMA and is considered a bearish signal.
The RSI indicator measures the strength of a currency pair. It is composed of a single line that oscillates between 0 and 100, and when the RSI is over 70, it is considered overbought, and it is considered oversold when it is below 30.
A bullish breakout occurs when the price action exceeds resistance and the RSI exceeds 70. A bearish breakout happens when the price is below support, and the RSI is below 30.
When trading breakouts, it is also essential to place a stop loss. A stop loss is an order that will close your trade if the market moves against you by a certain amount. For example, if you buy USD/EUR at 1.2500 and place a stop loss at 1.2475, your trade will be closed if the price falls to 1.2476.
The stop loss should be placed below support in a bullish breakout or above resistance in a bearish breakout, which will help you stay in your trade as the market moves in your favour and prevent you from being stopped prematurely.
The take profit is an order that will close your trade when the market moves in your favour by a certain amount. For example, if you buy USD/EUR at 1.2500 and place a take profit at 1.2550, your trade will be closed if the price rises to 1.2551.
Traders should place the take profit at a level where you expect the market to reverse, which will help you lock in profits as the market moves in your favour and prevent you from giving back all of your gains.
Forex breakouts can be a great way to enter the market and profit. However, it is essential to know what you are doing before trading. Be sure to practice with a demo account and only risk money you can afford to lose and use an experienced and reputable online broker before attempting forex trading.