When the price breaks out of a specific trading range, the phenomenon is called a breakout. Breakouts can also happen when the price breaches a particular price level such as support and resistance levels or pivot points. If you are trading on breakouts, your goal should be to enter the market has soon as the breakout shows itself and then hold your position until the volatility has vanished. Unlike other financial instruments, you cannot see the volumes being traded on the Forex market and this is a disadvantage because volumes are essential to breakout trading in normal circumstances. However, as we shall see, in addition to risk management, there are ways in which you can profit from breakouts.
If prices moved substantially within a short time frame, volatility can be said to be high and if there is no significant price movement within the same time frame, volatility can be said to be low. Many traders believe that high volatility makes for high profits and jump into the market only to lose money because of the difficulty of trading under these conditions. On the contrary, you should look for currency pairs with a low level of volatility. In other words, you can use volatility to your advantage if you position yourself properly for the spike in volatility if a breakout does happen.
Keeping track of volatility
There are some indicators available which can be conveniently used to gauge the volatility of the market and here are some of the more useful ones for breakout trading.
Moving Average-this is one of the most commonly used indicators by traders because it is simple to understand and use and can yet provide valuable information. As the name suggests, moving averages measure the movement of the market over a timeframe that you specify. For instance, if you use a 20 SMA on a daily chart, you can see the simple average movement of prices over a timeframe of 20 days. Other types of moving averages can include exponential moving average and weighted moving average.
Bollinger Bands-these are excellent indicators to gauge volatility because they were specifically developed for the purpose. They consist of two lines drawn at a distance of two standard deviations above and below the moving average for whatever time frame that you choose. In other words, if you set that at a time frame of 20 days and you prefer to use a moving average, you would end up with a 20 SMA with two additional lines, one drawn two standard deviations above the average and the other line two standard deviations below the average. The narrowing of the bands is an indication of low volatility and expansion is an indication of high volatility.
Average True Range-Average True Range (ATR) is another useful indicator of volatility because it provides information about the average range of trading in the market over the time frame that you specified. If you use a setting of 20 on a daily chart, you can discover the average trading range over the past 20 days. If the ATR is rising, it is an indication that market volatility is increasing and, conversely, if it is falling, it indicates that the volatility in the market is declining.
Categories of breakouts
Breakouts are important because they signal changes in the supply and demand. They can therefore lead to significant movements in the market and the opportunity to profit if you are familiar with the different categories. Continuation breakouts can happen when, after a significant movement in price in one direction, there is a lull in the market during which traders take stock of their position. During this lull, prices will tend to move sideways and the process is known as consolidation. If traders decide that the initial trend is correct and trade in a manner in which price is pushed in the same direction, this is known as a continuation breakout. All it means is that the initial trend will continue. Reversal breakouts start in much the same fashion in that there is a lull in trading after the initial movement. However, it differs from a continuation breakout because traders decide that the trend has ended and push prices in the opposite direction resulting in a price reversal. A false breakout can happen when the price breaks a level such as a support or a resistance level but does not continue in the same direction.
One good way of trading breakouts is to wait till the price executes a retracement back to the original breakout level and then observe whether it proceeds to touch a new high or a new low. Another way of profiting is not to establish a position at the first signs of a breakout but wait to see the direction of the price movement before you commit yourself. You may lose some of your potential profit but it is better to be safe than sorry.
A relatively easy way to spot a breakout is to look at the trend line. The more tops and bottoms connected by the trend line ( at least two at the very minimum), the stronger the trend is likely to be. Once the price approaches the trendline, it will either come back or continue through the trend line resulting in a breakout and a price reversal from which you can profit. Here is an example: