THE first step in trading a breakout is identifying support and resistance levels. These levels are identified by looking at the high and low of market price action over a specific time frame; intraday, daily, weekly, monthly or annually. A breakout occurs when the price of a currency moves above support or below resistance. A selling opportunity emerges on price breaks below support. A buying opportunity emerges when the price level breaks above resistance. The breakout of these levels may begin to establish a trend in the direction of the breakout. The goal is to enter the trade when the market breaks out and to profit from the new market trend.
For example, let’s assume that euro-dollar traded in a channel last week, oscillating between $1.3650 and $1.3710. A channel is formed by two parallel trend lines that connect the highs and lows of a price pattern. In this case, the low of the range, $1.3650, is support and the high of the range, $1.3710, is resistance. Once the support and resistance levels are established, you can buy the market on a break above $1.3710 or sell the market on a break of $1.3650.
The next step is the placement of a stop loss order. Breakouts often fail – this is known as a false breakout. False breakouts can create whipsaw price action and rapid reversal in price direction. Placing a tight stop – close to the level of the breakout – will help avoid a substantial trading loss should the breakout prove false. Using a breakout strategy for placement of stops is an excellent money management tool and helps preserve capital until a sustainable trend emerges.
Once the trend starts, there are a number of technical tools that can be used to set a profit target and exit point for the trade. The most common tool to stay with the trend is to use a moving average that helps identify the strength of the trend along with the placement of a trailing stop to protect a percentage of profit.