THE FUNDAMENTALS OF BREAKOUT TRADING

DailyFX Research Team

Table of Contents
Breakout Trading vs. Range and Trend Trading ................................................................. 3

Breakout Trading is the Step In-Between Range and Trend Trading .................................. 3
Identifying Breakout Patterns: Entry, Exit, and Order Type .................................................. 6
Identifying Breakout Patterns: Three Examples ................................................................... 7
Pitfalls of Breakout Trading – The “False Breakout” .........................................................15
Breakout Trading Strategy Checklist – 5 Ticks for Traders ..............................................19
Disclaimer ...................................................................................................................... 21

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Breakout Trading vs. Range and Trend Trading

Previous trading guides have covered price action environments defined by ‘ranges’ and ‘trends.’

Range trading rests on the belief that “traders should sell high and buy low” as prices will stay flat
over a period. In other words, “the range will hold.”

Trend trading, on the other hand, is predicated on the idea that “traders should buy in the direction of
momentum” as prices will continue to move in that direction for some time. In other words, “the trend
will hold.”

At their core, range and trend trading believe that traders should “buy into support” or “sell into
resistance.” Breakout trading takes the opposite approach. A breakout strategy focuses on selling
once support is lost or focuses on buying once resistance is breached.

Breakout Trading is the Step In-Between Range and Trend Trading

Breakout’ trading is the strategy that connects ‘range’ and ‘trend’ trading. Ranges break out into
trends; trends break out into ranges. Both range and trend trading are tied together by the common
belief that “price action will stay the same.”

Breakout trading takes the opposite approach, that “price action will change”: the range will break, or
the trend will change direction.

Example of Price Action Evolution: Bull Trend, to Range, to Bearish Breakout

One way to conceptualize the evolving relationship among trends, ranges, and breakouts is to review
historical charts. One such example is the 2018 USDJPY daily rate chart. For most of 2018, USDJPY
rates were rising at a steady clip, holding an uptrend from the March and August lows.

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USDJPY Technical Analysis: Daily Rate Chart (March 2018 - December 2018) (Chart 1)

Source: TradingView; chart created by Christopher Vecchio

But by the end of October 2018, USDJPY’s uptrend started to crack. Several tests below the uptrend
between late-Oct. and mid-Nov. suggested that bullish momentum was starting to fade. The
subsequent swings to the topside in early- and late-Nov. produced lower highs than in October.

USDJPY Technical Analysis: Daily Rate Chart (March 2018 to early 2019) (Chart 2)

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By Dec. 2018, USDJPY’s trend had given way and shifted into a sideways range. The attempted retest
to climb back above the uptrend from the March and August 2018 swing lows was cut short. A failed
retest of a trendline is often a strong indication that the trend has been negated.

USDJPY Technical Analysis: Daily Rate Chart (April 2018 to early 2019) (Chart 3)

Source: TradingView; chart created by Christopher Vecchio

The sideways range failed in mid-December 2018, less than 24-hours after the Federal Reserve’s final
policy meeting of the year. The bearish outside engulfing bar that formed on December 20 not only
marked a break of the sideways range that began to form in early-November, but also saw the October
monthly low broken; the series of higher highs and lower lows was officially busted. Soon after, the
January 2019 Japanese Yen flash crash saw the USDJPY breakout drag prices back down towards
their March 2018 low.

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Identifying Breakout Patterns: Entry, Exit, and Order Type

Finding appropriate entry and exit points for breakout strategies, like any trading strategy, requires
disciplined risk management. However, given the nature of breakout trading – waiting for trends to
change or ranges to break – identifying levels pertinent to risk management may not be that difficult
of an endeavour, even for new traders.

This means traders simply need to identify both resistance and support in a consolidation or a trend
prior to looking for a breakout opportunity.

Entry

Long position initiated with a ‘Buy Stop Entry Order’ above the range/trend resistance.

Short position initiated with a ‘Sell Stop Entry Order’ below the range/trend support.

Timing the exit in a trade predicated on a breakout strategy can be done in three different ways.

Exit Method #1 – Fixed Stop at Consolidation Resistance/Support

If long on a bullish breakout, the ‘Sell Stop Loss Order’ is placed below the range/trend support.

If short on a bearish breakout, the ‘Buy Stop Loss Order’ is placed above the range/trend resistance.

Exit Method #2 – Fixed Stop at Breakout Candle High/Low

Exit Method #3 – Trailing Stop

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Identifying Breakout Patterns: Three Examples

Breakout trading strategies are often aimed at charts where there are chances of continuation, or,
that prices will continue to move in the direction of the trend prior to entering the consolidation.

But for new traders, its best to keep an open mind: approach consolidation patterns with a neutral
perspective, allowing for outcomes on either side of support or resistance. Risk management is
paramount.

To this end, there are three main patterns that traders should look for when scanning the charts for
breakout trading opportunities: triangles/pennant); range/sideways consolidations; and head and
shoulders/inverse head and shoulders.

1. Triangle/Pennant

Triangles and pennants, while different in form, are essentially the same in principle: a pause in a
trend prior to continuation. Trends require at least two points of contact; triangles/pennants are
characterized by at least four lower highs and higher lows (two to form support, two to form
resistance) to mark the consolidation zone.

Here’s an example of a triangle in copper futures (via the September 2021 contract).

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Copper Prices Technical Analysis: Daily Price Chart (January 2020 to April 2021) (Chart 4)

Source: TradingView; chart created by Christopher Vecchio

Between February and early-April 2021, copper prices were trading in a triangle pattern, having entered
the consolidation after rising in an uptrend for several months prior. The initial measured move called
for a return to the apex of triangle resistance, to the February 25 high at 4.3755.

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Copper Prices Technical Analysis: Daily Price Chart (January 2020 to May 2021) (Chart 5)

Source: TradingView; chart created by Christopher Vecchio

With copper prices trending higher prior to the consolidation, the expectation was for a bullish
breakout from the triangle. In April 2021, copper prices broke above triangle resistance. The
breakout’s initial measured move was achieved at 4.3755 by April 26, 2021.

2. Range/Sideways Consolidation

Ranges/sideways consolidations are also known as “horizontal trends,” insofar as they have points
of contact forming resistance and support that effectively equidistant; there are equal highs and equal
lows. Ranges/sideways consolidations are effectively neutral consolidation patterns, with potential
for continuation or reversal.

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GBPJPY Technical Analysis: Daily Rate Chart (June 2018 to June 2019) (Chart 6)

Source: TradingView; chart created by Christopher Vecchio

GBPJPY prices were consolidating between mid-February and early-May 2018, carving out a near-
500-pip range/sideways consolidation. Unlike the DXY Index triangle example, which was defined by
resistance with lower highs and support with higher low, the GBPJPY sideways range is defined by
near-equal highs and near equal lows.

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GBPJPY Technical Analysis: Daily Rate Chart (May 2018 to August 2019) (Chart 7)

Source: TradingView; chart created by Christopher Vecchio

The bearish outside engulfing bar on May 8, 2018 marked the breakout from the range/sideways
consolidation. The measured move for the consolidation (between 143.72 and 148.87, 515-pips)
called for a drop down to 138.57. The measured move was achieved on May 29.

The GBPJPY chart highlights because traders shouldn’t set an “absolute” limit on their targets; using
a trailing stop, or only taking partial profit, would allow for traders to maintain positioning in the event
that the trend were to continue. Indeed, the bearish breakout moved beyond the measured move; by
the end of July 2019, GBPJPY was trading below 133.00.

3. Head and Shoulders Pattern, Inverse Head and Shoulders Pattern

Head and shoulders patterns are reversal patterns, marking a top in prices. On the other hand, inverse
head and shoulders patterns mark bottoms in price trends.

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But these patterns do not need to form at the absolute highs and lows in trends. A head and shoulders
pattern at a bottom is a bearish continuation pattern; an inverse head and shoulders pattern at a top
is a bullish continuation pattern.

Both patterns are defined by three peaks in price action: the first and third peaks produce minor moves
defining the “shoulders”; and the second peak produces the most extreme move and defines the
“head.”

Both shoulders and the head will see their price moves retrace back to the same base, which is known
as the “neckline.”

Gold Technical Analysis: Weekly Price Chart (July 2011 to August 2019) (Chart 8)

Source: TradingView; chart created by Christopher Vecchio

Here’s an example. Looking at the gold price weekly timeframe, an inverse head and shoulders pattern
at trend lows – a bottoming pattern – formed between early-2013 and mid-2019.

The gold price rally in June 2019 may marked the continuation of the bottoming effort after breaking
the multi-year descending trendline from the 2011 high.

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The turn lower at the end of 2018 appeared to be a right shoulder in a multi-year inverse head and
shoulders pattern, with the head forming at the November 2015 low at 1046.23.

Ultimately, the placement of the neckline determines the final upside targets in a potential long-term
gold price rally.

Conservatively, drawing the neckline breakout against the January 2018 high at 1365.95 calls for a
final target of 1685.67. Aggressively, drawing the neckline breakout against the August 2013 high at
1433.61 calls for a final target at 1820.99.

Gold Technical Analysis: Weekly Price Chart (July 2011 to August 2019) (Chart 9)

Source: TradingView; chart created by Christopher Vecchio

Identifying Breakout Patterns: Finding Price Targets – “Measured Moves”

Depending upon the type of consolidation pattern, the final price target for the breakout strategy will
vary accordingly. Identifying a price target identifies a minimum level trader should expect price to
reach during a breakout and will help traders remain objective during periods of countertrend
movement. Traders can identify targets – the “measured move” – for breakouts in the following ways:

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Triangles/pennants

Take the difference between the first support and resistance points that formed the triangle/pennant
to find the measured move.

On a long position:

The initial target will be the price of the first point that formed resistance; and the final target will be
the measured move plus the bullish breakout price.

On a short position:

The initial target will be the price of the first point that formed support; and the final target will be the
bearish breakout prices minus the measured move.

Ranges/sideways consolidations

Take the difference between support and resistance to find the measured move.

On a long position, the final target will be the measured move plus the price of resistance. On a short
position, the final target will be the price of support minus the measured move.

Head and Shoulders/Inverse Head and Shoulders Pattern

Take the difference between the head and the neckline to find the measured move.

On a long position (inverse head and shoulders), the target will be the measured move plus the
neckline bullish breakout price. On a short position (head and shoulders), the target will be the
neckline bearish breakout price minus the measure move.

Using Volatility as a Filter

When trading stocks, bonds, commodities, or futures, market participants can monitor trading
volumes. Operating through centralized exchanges, traders can use volumes to determine rates of
participation underlying price action.

For example, imagine that a stock’s price has been consolidating in a sideways range marked by low
volume. Then prices leave the range, volume increases dramatically. The higher rate of participation

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increases the likelihood that the breakout is valid. In contrast, if volumes don’t rise during the
breakout, the lack of participation decreases the likelihood that the breakout is valid.

Unfortunately for FX traders, there are no centralized exchanges. As such, there are no reliable
measures of trading volumes that accurately capture positioning shifts in the market in real-time,
unlike stocks, bonds, commodities, or futures.

Instead, traders may want to monitor implied volatility instead of volume. Implied volatility measures
capture the expected price range over a given period. A simple rule of thumb is thus: when prices
leave a consolidation, look for breakout confirmation by a rise in short-term (overnight and 1-week)
implied volatility measures.

Pitfalls of Breakout Trading – The “False Breakout”

Trading breakouts, like any other strategy, does not guarantee profitable outcomes. Indeed, that is
why there are false breakout strategies.

What is a “false breakout?” If a breakout occurs when a ranges or a trend’s support or resistance
breaks, then a false breakout occurs when price action gives the appearance of a break from a range
or trend, but price ultimately returns into said range or trend.

Here’s an example of a false breakout in USDJPY:

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USDJPY Technical Analysis: Daily Rate Chart (March 2018 to August 2019) (Chart 10)

Source: TradingView; chart created by Christopher Vecchio

In July 2019, USDJPY rates attempted a bullish breakout from the downtrend from the April 24 and
July 10 swing highs. Support had formed against the June 25 and July 18 lows.

However, after five days into the bullish breakout attempt, USDJPY rates were not able to clear the
former swing high set on July 10. This was a warning sign to traders.

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USDJPY Technical Analysis: Daily Rate Chart (March 2018 to August 2019) (Chart 11)

Source: TradingView; chart created by Christopher Vecchio

The false breakout was marked by a bearish outside engulfing bar on August 1 that saw USDJPY
rates return into the downtrend from the April 24 and July 10 swing highs.

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USDJPY Technical Analysis: Daily Rate Chart (March 2018 to August 2019) (Chart 12)

Source: TradingView; chart created by Christopher Vecchio

With USDJPY rates also falling below the uptrend from the June 25 and July 18 lows, this was a clear
false breakout. Less than one month later, USDJPY rates had continued to trend low following the
August 1 bearish outside engulfing bar.

Although traders may have initially taken the wrong side of the trade on the false bullish breakout
attempt, prudent risk management may have minimized losses by quickly exiting the position and
flipping to the short side.

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Breakout Trading Strategy Checklist – 5 Ticks

for Traders

A quick recap: breakout trading strategies are the link between range and trending trading strategies;
ranges breakout into trends; trends breakout into ranges. Here are the five things’ traders need to do
in order to effectively run a breakout strategy:

1. Find Opportunities for Breakout Trades

Look for triangles/pennants, ranges/sideways consolidations, and head and shoulders/inverse head
and shoulders with clearly defined resistance and support in prices

2. Wait Patiently – Stick to the Plan!

Only take breakout trades when prices breach clearly defined resistance or support; for more
conservative traders waiting for confirmation, this may include waiting for a retest of the breakout
price level.

3. Calculate the Measured Move

Once you’ve identified the breakout pattern candidate, find the appropriate measured move to
determine the trade’s price target.

4. Calculate the Risk

Always use stops! Fixed Stops or Trailing Stops are necessary in a breakout strategy in the event of
a false breakout.

5. Stay Objective – Stick to the Plan!

By defining your target and stop ahead of execution, traders can reduce the emotional influence of
watching price action unfold in real-time. Once price targets and stops are determined, there’s no
reason to risk capital with emotional reactions.

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