There are dozens of breakout strategies available for traders, but the Forex breakout strategy you’re about to learn is my favorite. This strategy has been responsible for some of my biggest gains over the years.
In this lesson, you will learn how to identify the configuration, when to enter the market, and how to identify possible targets. We’ll also take a look at several examples on both the 4-hour chart and the daily chart. I found these two time frames to work better when trading on this breakout strategy.
What is a Breakout?
Before we get into my favorite Forex breakout strategy, let’s first define the term “breakout”.
A breakout is any price movement outside of a defined support or resistance area. Breakout can occur horizontally or diagonally, depending on the price action pattern.
Let’s take a look at two illustrations of one of the most common breakout patterns that occur in the Forex market. The first illustration shows a bullish breakout pattern.
Note in the illustration above, we have a market that is trending upwards but has found resistance at a horizontal level. After two failed attempts, the market finally breaks the resistance. This signals a bullish breakout from a key resistance level.
The next illustration we will see is a bearish breakout.
Just as you would expect, the bearish breakout is similar to a bullish breakout, only this time the market breaks to the downside. After two failed attempts, the market finally breaks through the support. This signals a bearish breakout from a key support level.
The reason why these breakouts are such an important trading strategy is because they often represent the beginning of increased volatility. Waiting for a break of a key level, we can use this volatility in our favor by joining the new trend at the beginning.
The only Forex breakout strategy you’ll ever need
This particular Forex breakout strategy is the one I have been using for years. It has become my preferred model to trade, partly because of its reliability and partly because of the more than favorable risk/reward ratios it often produces.
There are four parts to this Forex breakout model.
- support
- resistance
- escape
- Retest
The illustration above is very similar to the first two illustrations. The main difference here is that instead of having a trend line and a horizontal line, we have two trend lines. One trend line acts as a support while the other acts as a resistance. This forms what is known as a “wedge”.
Breakout to this pattern occurs when the market eventually breaks down on one side or the other. While a wedge is typically a continuation pattern, I tend to trade it based on how the market breaks down. In other words, I let the market show its hand before making any considerations about the future price movement.
Now let’s apply this same pattern to a 4-hour USDJPY chart.
Note how in the chart above, the market had made its way into a wedge pattern. When the market began to consolidate tighter, it eventually broke the wedge support and subsequently retested this support level as a new resistance.
This new test offered traders a perfect opportunity to get short.
Execution of the Forex breakout strategy
To get a good idea of the setup in action, let’s take a look at every step, including the entry strategy and where to place your stop loss.
Entrance
Most of the time your entry will come on a new previous support or resistance test. However, it is important to note that depending on how strong or weak the market is, you may not get a new test. We’ll talk about this in more detail later in the lesson. For now just know that it is better to get into a new previous support or resistance test, depending on how the market breaks down.
Stop Loss
Your stop loss should be placed above or below the breakout candle, at a minimum. In the case of the USDJPY breakout pattern below, your stop loss should be placed above the candle that broke the support.
In the chart above, the market broke the wedge support on the breakout candle and subsequently re-entered the previous support as a new resistance. This new test presented the opportunity to become short with a stop loss above the breakout candle.
Setting a goal
Now that we know where to enter and where to place our stop loss, let’s discuss how to set a goal. As you may know, I’m a big fan of using simple price action levels. So you can probably guess how we are going to set a profit goal.
Here’s a much broader look at the USDJPY chart. This time, we are looking at the daily time frame to see if we can identify a logical target for our breakout trade.
The first thing you will notice is the strong area of support that has been in place for several months. This makes an ideal area to target for our commercial setup.
So, what kind of risk/reward ratio have we gotten from this business setup? Let’s take a look.
In the USDJPY chart at 4 hours above, we can see that the stop loss was 13 pips from the entry while the take profit was 50 pips from the entry. This gives us a 3.8R (50/13). In other words, if you had only risked 2% on this trade, you would have gained 7.6% (3.8 x 2%).
While this is an impressive gain on its own, what is even more impressive is the fact that you would have made 7.6% in just 32 hours.
Further analysis
Let’s turn our attention to another example of the Forex breakout strategy. This wedge pattern occurred on the 4-hour GBPNZD chart. One of the main differences here is that there was no new test of the previous support once the market broke down.
Note in the GBPNZD chart above, the market failed to retest the previous support before losing 430 pips. But just because the market doesn’t re-enter the previous support doesn’t mean we have to lose the trade.
The new test we look for as part of this Forex breakout strategy typically comes within the next candlesticks. So, if the market starts moving sideways for more than three or four periods, there’s a good chance the market won’t give a full new test.
Let’s take a closer look at the GBPNZD trading setup.
In the GBPNZD chart at 4 hours above, note how the market begins to move sideways over several periods. This is a good indication that the market does not have the strength to retest the former wedge support. When you see this happening, it’s generally a good time to use a market order to join the upcoming trend.
Here is the GBPNZD breakout trade from start to finish.
For this configuration, our stop loss was 45 pips from the entry. Remember that you want your stop loss above or below the breakout candle. Since this is a short setup, our stop loss has been placed above the breakout candle.
Our take profit, on the other hand, was 175 pips from the entrance. The target was identified by the recent minimum that was made several weeks earlier. Note that the market fell the following week and ran for another 150 pips before reversing.
Although this sounds great in hindsight, the logical goal at the time was 175 pips away, which still produced a very healthy 3.9R trade. So, if you had risked 2% on this trade, you would have been left with a profit of 7.8%. This particular setup took only 36 hours from start to finish – not bad to be able to make a profit of 7.8% in 36 hours risking only 2%.
Forex Breakout Strategy: The Real Potential
As I conclude this lesson, I want to leave you with one last configuration. This particular breakout occurred on the USDJPY daily chart and represents what is possible with the Forex breakout strategy you learned today.
The first thing you’ll notice is the period of time the market consolidated within this wedge pattern before breaking to the upside. The above configuration was formed on the daily chart, so from start to finish this consolidation period lasted 180 days.
This brings me to an important observation about the Forex breakout strategy: the longer the market consolidates, the more volatile the breakout will be. This is not always the case, but 9 times out of 10 the market respects this idea of matching the duration of consolidation with the level of volatility.
For those who were able to enter this trade at the breakout point and ride the trade until the consolidation period (take profit level) there was a huge gain to be made. A stop loss below the breakout candle meant a stop of 50 pips with a potential gain of 600 pips. This works for a very healthy 12R trade. At just 2% risk you would have made a staggering 24% profit.
Although rare, these 10R+ trades occur from time to time. And with the knowledge you’ve gained in this lesson, you’ll be able to identify and profit from these patterns with ease.
Summary
I hope this lesson has opened your eyes to what is possible with a simple Forex breakout strategy. Just remember that like any other trading strategy, this breakout strategy is not without flaws. Therefore, always make sure to maintain an adequate risk/reward ratio and use a favorable stop loss strategy on each trade.
We covered a lot of content in this lesson. Here are some of the highlights to keep in mind when you start implementing this trading strategy in your game plan.
- A breakout is any price movement outside of a defined support or resistance area
- Forex breakout strategy has 4 parts: support, resistance, breakout and retest
- The new test of the previous support or resistance gives a trader the opportunity to enter the market
- If a market starts moving sideways for more than three to four periods after a breakout, there’s a good chance the market won’t produce a new previous support or resistance test.
- Your stop loss should always be placed above or below the breakout candle (at a minimum), depending on how the market breaks
- It is advisable to use price action levels to identify potential targets for this breakout strategy: a good starting point is the recent swing high or low
- As a general rule, the longer a market consolidates, the more volatile the resulting breakout will be.
Frequently asked questions
What is the best breakout strategy?
Something as simple as a wedge or channel pause is my preferred method for breakout trading. Keep in mind that no two traders are the same, which means that the “best” strategy is the one that works best for you.
Are breakout strategies reliable?
absolutely! As long as you take the time to develop a trading advantage and stay patient, breakout strategies like the one taught here can be reliable and incredibly profitable.
What is the best time frame to trade breakouts?
It’s subjective, but I’ve found that the 4 hours and daily time frames perform best when negotiating breakouts.
Do you need indicators to trade breakouts?
Price action is all you need. Some will support it, and that’s fine. But in my experience, nothing beats raw price action for trading breaks.