Breakout Zones Trading Method and Indicator
The breakout zones indicator represents a MetaTrader 4 indicator. It is used with forex trading strategies to confirm entry or exit points. In this article, we overview:
Breakout zones and what they mean
Finding a trend from a range
How to trade breakout zones in Forex
Importance of risk management when trading breakout zones indicator
Breakout zones and what they mean
In their simplest form, breakout zones are simply the transition step between a range and a trend.
Of course, some breakout zones may simply be in another range once a new high or low is set. But quite often, at least a permutation of the trend that will lead, once the support is previously set, or the yield to resistance to soaring prices.
These rapidly moving markets can usually be accompanied by fundamental news releases, which make the resulting conditions even more exciting.
And it is because of the nature of these breakout zones that traders can be strategic in attacking conditions that could lead to a profit.
Traders can use very simple breakout zones indicator for entries on breakout positions and plan risk management to ensure the correct breakout protocols are in place. But before we talk about strategy, a word of warning.
Breakout zones can lead to as many losses as profits. That’s because breakout entries that aren’t made with proper risk management can completely drain a trader’s account. If it’s a market-moving fast enough, it can move in the opposite direction even faster than initially.
And if a stop is not on a trade, or if the leverage used is too high, the results can be catastrophic.
So good risk management should always be used – no matter how good the trade idea. At its lowest denominator, every trade is just an idea…don’t let a simple idea end your career or drain your account.
Finding a trend from a range – Breakout zones
Like a butterfly emerging from a cocoon, trends often begin after price breaks out of an already defined pattern of congestion or consolidation.
Prices often move for one reason or another. Central bank statements have been a common cause for a breakout recently.
Traditionally, data releases are the significant cause of support or resistance breaks. They send shock waves through the markets as traders try to integrate new information.
Unfortunately, when news or data hits the market, it’s often too late to catch the breakout in time.
Instead, the risk of entering could be even greater as the chance of a pullback emptying the trader’s account makes the prospect of trying to catch the move risky…at best. It is often better to pause and wait for the trend to develop if you miss the initial breakout.
So, traders can incorporate a very simple technical indicator to help them look for ranges that could eventually turn into breakouts.
Finding an entry point
There are many options to do this; the simplest is to note the high or low before prices started congesting.
Traders can use entry orders to “buy new highs” or “sell new lows.”
If traders want to use an indicator that can help them determine these levels, Price Channels, also known as Donchian Channels, are a great fit. They will show them the “highest high” and “the lowest low” as well as low” over the last x periods (x being the number of periods used as input).
It often takes more than one try to find break zones.
This extreme rally in volatility makes trading breakouts so tricky. The accompanying price movements can significantly swing in both directions. So, there will be many instances where support and/or resistance are breached before prices reverse and move in the opposite direction. These are the false breakout zones that everyone is afraid of.
Because of the higher volatility around these announcements, and given the risk of a false breakout, traders often need to focus more heavily on risk and reward while being more aggressive. Getting rid of losers even faster while looking for bigger profit targets on the right side of the trade.
Breakout zones – Probabilities
When a trend becomes observed in the market, the trader may enter the trade, hoping that the trend will continue. Or, to put it more simply, traders could have the odds in their favour simply by trading in the direction of the trend.
In a range-bound market, often you can’t see any trend. Prices are stuck between support and resistance. If prices go too high, traders sell; traders buy if they go too low. In order to break out of these areas of support or resistance, the market often needs a catalyst, like news in the media.
And when we have that catalyst, volatility picks up, and prices start to move a lot more. This means that there are plenty of opportunities where support and resistance will be breached during this period of volatility before prices reverse and move in the other direction.
These false breakouts can make trading in this condition very frustrating. This is why it may be best for new traders to focus on the more conventional trend-based market conditions.
Traders often give breakout strategies a lower probability of success because of the reasons we have discussed. If a trader thinks he can normally win on every second trade, he will win every fourth trade.
Since breakouts have a lower probability of success, traders should adjust reward-risk ratios accordingly. They should seek even tighter stops and even wider profit targets.
In The Biggest Mistake Forex Traders Make, we recommend looking for a minimum 1 to 1 risk gain. As breakouts often have a lower probability of success, traders should be even more aggressive in seeking at least $2 for every $1 risked.
How to trade breakout zones indicator in Forex
The key to trading breakout zones indicator is support and/or resistance. These levels that can experience changes in order flow are the same prices traders can look to enter on breakouts.
Pivot points are a very attractive option for breakout traders. Traders can watch these price levels to look for breakout moves while placing entry orders outside these prices so that as soon as the pivot point gives way to such a price rise, entry is initiated, and the trader is on position.
Another common option for breakout trading is to include the price channels indicator (often referred to as ‘Donchian Channels,’ after famous breakout trader Richard Donchian).
The price channels show the highest and lowest levels over x past periods (where x is the number of candles the trader wants). When prices approach these levels, they may continue to higher highs or lower lows; and that is the definition of a breakout entry.
The same logic can be used for psychological numbers or round levels like 1.3500 for EURUSD or 0.9000 for AUDUSD.
These round price levels often experience more stops or limits. They can bring a trend to a screeching halt, at least temporarily. But when there is a second approach toward this level, it is possible that the number of stops or limits cannot contain all the selling (or all the buying for an uptrend).
This creates one of the most common ways of trading breakouts; incorporate quotes and past market movements into the analysis.
By noting the price levels the market has followed in the past, traders can try to place entries outside of these prices. So, if a move towards these levels is strong enough – the position is opened.
One can combine price action with other support and resistance mechanisms, such as psychological levels, Fibonacci, or pivot points to look for the ‘strongest’ support and/or resistance levels.
The fact that the market has respected these levels in the past through price action can serve as confirmation that the price has been important in the past; if the price approaches again, it might not be more important in the future.
The point of breakouts is not their predictability: breakout zones are anything but predictable! The advantage of breakouts is the quick movement that can follow them: so if the traders are on the right side of the move, and if the move continues in favour of the trader, they may potentially be able to profit from the said move. That’s a lot of “ifs.”
Very simply, a rapidly changing market can turn around just as quickly. Or a rapid spike in volatility may just break past support or resistance, triggering a breakout entry. That can put the trader in a very precarious position.
You cannot predict the future. And that is precisely why risk management is so important in all aspects of trading. Because breakout zones are fast-moving and volatile, the degree of instability can be considered to be even higher than in normal, range-bound or trending markets.
The main reason traders fail is using the wrong risk-reward ratio. Traders should always, at a minimum, aim for a potential gain equal to what they are willing to lose on the “risk” side of their trade.
In the case of breakouts, traders should aim for even greater profits relative to the risk taken. Finally, if the breakout turns out to be a big move, it should be possible to get a bigger return. And if the trade turns out to be a dud, the losses will be minimal.