What is a breakout strategy in trading?
When the price breaks out of its range, a breakout strategy seeks to enter the trade. Strong momentum is what traders seek, and the breakout itself serves as a signal to enter a position and take advantage of the ensuing market movement.
Traders may place buy-stop and sell-stop orders, or they may take positions in the market, in which case they will need to closely watch the price movement. Usually, they will set the stop slightly above or below the previous support or resistance level. Traders can use traditional levels of support and resistance to determine their exit targets.
It’s a good idea to understand the levels of support and resistance before moving forward. It will be much easier to spot the price breakout from those levels once you are aware of that.
What exactly is a support level?
If you trade using technical analysis, a chart over time will reveal some support levels, or regions or particular levels where prices are typically supported.
Prices are said to have a “floor” when support levels are present. This indicates that because prices have the backing of buyers, they typically remain at this level.
What exactly is a resistance level?
A level of resistance is the antithesis of a level of support.
By examining a chart, one can identify resistance levels, or places or levels at which prices are typically stopped (resisted) and are unable to rise further for a while.
You can see the levels of support and resistance in this example. Determining the support and resistance levels is crucial if you wish to employ the breakout entry strategy.
This is so because levels of support and resistance are regarded as reliable indicators of when prices are likely to pause.
How to trade using a breakout entry
Using the breakout entry to enter a trade after the price breaks through a resistance level is one strategy. Many traders believe that the price has the momentum to move higher when it breaks through the resistance level.
The idea behind this is that traders who see a breach of resistance may be bullish and will encourage the price to rise. Many traders use this breakout from a resistance level as an entry point, though this may not always be the case.
Conversely, in the event that the price breaks through a support level, you can employ the breakout entry. A breach of support is typically interpreted as a warning that prices could decline even more. This breach of support is exploited by certain traders to profit from price declines.
You can use this entry strategy for trading if you understand what support and resistance levels are and how to use them to determine when prices are breaking out of these levels.
The MT4 trading platform’s charting feature can be used to determine support and resistance levels whether you’re using a live or demo trading account.
Attempting to determine the support and resistance levels on various instruments at various times is also a very good idea.
It might be much simpler for you to recognize any price breakouts once you are comfortable with and knowledgeable about these levels.
The price breakout is merely one of several entry techniques at your disposal for trading. Check out our eBooks about various entry and exit strategies if you’d like to learn more about other entry strategies.
You should also keep in mind that, although trade entries are significant, they are only one aspect of your trading as a trader.
Having a good entry strategy is crucial. Nonetheless, having a rigorous risk management and exit strategy is equally important. When used in tandem, entry, risk management, and exit strategy can assist you in developing into a knowledgeable trader.
Which indicator works best for the breakout strategy?
Indicators can be used as an entry signal as well as a supporting tool in breakout strategies based solely on price action, as demonstrated above with support/resistance levels.
The Ichimoku Cloud is one type of trading indicator that can be applied to a breakout strategy.
When the price breaks through the cloud, a trader would buy; when the price drops below the cloud, they would sell.
The Relative Strength Index, or RSI, indicator can be used to look for confirmation and divergence.
When both the price and the RSI are moving in the same direction, we talk about confirmation. Let’s examine the AUD/JPY chart below, highlighting the mid-July breakout.
Both the price and the RSI were already trending downward. The RSI was approaching but had not yet reached the oversold area at the time of the breakout. This is an additional indication that the negative could still have more room.
Here’s another example, where we examine the EUR/NZD pair and a bearish RSI divergence that emerged in the middle of August.
The important 1.71 resistance level was broken by the price, but the RSI was already in overbought territory and there was a bearish divergence. This would have served as a warning to pass on purchasing the breakout. The chart shows that there was a consolidation rather than a sudden increase, and that there was a sell-off soon after the consolidation ended.
Which time frame works best for trading breakouts?
One can trade breakouts at any point in time. A breakout below a multi-year support level could be traded, and you could hold the trade for several months.
Breakout trading is more common among short-term traders, though, as they aim to capitalize on swift market movements that happen in a brief amount of time. Trading on the lower time frames instead of the higher time frames makes it much easier to get a sense of the market and its momentum.