Stacking the Odds in Your Favor

11/21/2013 6:00 am EST

Focus: FOREX

Because the forex market is known for its strong trends, a lot of traders favor using a breakout strategy when trading it, but Richard Cox at DailyForex.com cautions that there are other factors to take into consideration beforehand.

Whether you are new to day trading or have been in these markets for a long period of time, one thing is clear: You have been exposed to the term “breakout" as a major market occurrence and a potential opportunity to see significant market gains. Breakouts signify important changes in market sentiment, and this could happen for a variety of reasons. Perhaps an important news release or a piece of economic data has changed the market's perceived value of an asset. This can be represented visually on a price chart as the underlying activity literally “breaks through” important levels of support or resistance. A break of support would be a bearish breakout. A break of resistance would signify a bullish breakout is in place.

Watching Market Volumes
“Once we have an understanding of the mechanics of a forex trading breakout,” said Haris Constantinou, currency analyst at TeleTrade, “we next need to learn how to increase the probabilities in these trades so that we can maximize gains relative to the market majority.” One way of doing this is to look at market volumes as these support or resistance breaks occur. If trading volumes are low, it is a signal that a majority of the market is not behind the breakout move and that there is a possibility of a “false break." Because of this, it is generally prudent to wait for breakouts that are accompanied by higher trading volumes. Higher trading volumes will show you that a majority of the investment community is in favor of the direction in which prices are moving. This is a better indication that prices will continue in this direction in the future. Without this confirmation, the probabilities for a successful trade are lower.

Watching for Follow Through
In addition to this, forex breakout traders that tend to be successful will also be looking increased volatility (follow through) after the breakout occurs. After a significant break of support or resistance, follow through will depend on increases in volatility, which are usually generated by stop losses that were put in place by traders on the wrong side of the break. So, for example, traders that were bearish when an upside breakout occurs will ultimately be forced to exit those positions. These bearish trades then, in effect, become new buy orders that propel prices even higher. The reverse scenario would be true for a bearish breakout. Always remember, without these price extensions and increases in volatility, breakout traders will be vulnerable to a “false breakout” scenario that can quickly result in losses if not managed properly.

So, when we are looking to employ a well-structured breakout trading strategy, all of these factors need to be taken into consideration. It is not enough to simply look at breaks of support or resistance by themselves. Watching volume and follow through can help to greatly improve trading probabilities.

By Richard Cox, Contributor, DailyForex.com

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