How 'Not to Trade' Breakouts

07/23/2014 6:00 am EST

Focus: STRATEGIES

In this article, the staff at FXTM explains the right and the wrong way to trade breakouts and the reason for their popularity.

Breakouts are classic price patterns that traders have been using for years to make profitable trades. Breakouts work so well because they indicate a market that has started a new trend, one which could ultimately last for a long time and lead to spectacular profits.

In short, they signal a complete change in direction for the market.

As with any technical pattern however, breakouts work best when used in the correct way. Trading a breakout that is not true will ultimately lead to whipsaw and trading losses.

Never buy a breakout before it happens

Some traders like to trade breakouts but they also think they can anticipate exactly when they will occur. By doing so, they believe they will be able to get in before the breakout and get a better entry point. It’s not a good idea because you can’t successfully anticipate breakouts. For the sake of a couple of pips extra profit it just isn’t worth it.

Never wait for a pullback

Once a breakout has occurred, traders sometimes have a problem pulling the trigger at the higher price level. You see, it’s human nature to become accustomed to the recent price level and when a market goes up, it automatically looks expensive.

Some traders see a breakout happen but don’t trade it straight away. Instead, they wait for the market to pull back 3% or 5% before entering a new position. This is not very successful however because markets that pull back end up being false breakouts and the ones that don’t pull back are the ones that go on to make big profits.

Don’t buy an arbitrary oscillator breakout

Most technical indicators have a way of illustrating breakouts and can be useful for entering into new price trends. However, technical indicators should never be used on their own to judge a breakout.

For example, if the Relative Strength Indicator (RSI) moves past the 80 level, it’s a bullish signal but it should only be considered a breakout if the price level has moved to a new high too. Oscillator breakouts are meaningless unless confirmed by real price action.

Don’t chase a breakout after a big upward move

When a breakout occurs, it’s generally a good idea to follow it and buy into the strength. But, there are occasions when a market makes exponential new highs and it seems foolish to buy into another higher level breakout. And it usually is.

Breakouts tend to work out much better when they are coming from a smooth price range or upward trend.

By the Staff at FXTM

Related Articles on STRATEGIES