Published On: Mon, Jan 28th, 2013

How to Develop a Strategy Using Technical Analysis

One of the most commonly used Forex Strategies is trading breakouts because it is simply to execute and can generate impressive profits. The primary feature of this strategy is that, if the price of an asset has been trading for an extended time period within a constricted range, then when it does eventually breakout it normally advances in its new direction for some considerable distance, as illustrated on the following diagram.

trading strategy

Consequently, your first step in constructing a Breakout Strategy is to devise a technique that will detect assets that have been trading within a restricted range for a considerable period of time. Once this goal is accomplished, you can then define entry criteria that will be initiated once price breakouts.

Although a breakout strategy is applicable to all currency pairs, you are recommended to utilize it with the majors initially. This is because their trading patterns are easier to analysis and they exhibit lower spreads. When a currency pair is range trading, it is confined within a resistance or ceiling and a support or floor. Frequently, price will rebound against these levels numerous times before it finally emerges. For instance, envisage that the EUR/USD has bounced against its resistance located at 1.3150 several times. As such, when it does finally breach this level then this is a very strong indication that you should activate a new long trade.

You can use technical analysis to monitor and track breakouts. This is best done by studying trading charts utilizing the longer time frames from the daily upwards. This is because the statistics that they generate is of a superior quality than their shorter-frame counterparts. Once you detect a breakout, you should also wait until the present time-frame closes in order to confirm that the breakout is real and not a false reading or fakeout.

A potential drawback to seeking such confirmation is that there always exists the chance that price could quickly accelerate in its new direction before you are able to instigate a new position. Should such an eventuality occur, then you will just have to forego this opportunity and seek others. However, more frequently than not and if you are impatient and fail to wait for the period close, then a false signal could materialize causing your new position to be quickly stopped-out.

When price does surge out of its restricted range, a retraction often results dragging it back towards its initial breakout level. Many investors postulate that such an action is deliberately forced by large banking institutions with the intent of stopping-out the new positions of less experienced traders. However, this has never been confirmed.

If you do detect a retraction, then you should place an entry order at the point of the initial breakout supported by a stop-loss of about 50 pips. Such opportunities will enable you to initiate a breakout trade with maximum profit potential at minimized risk. Always look for positions that can increase your risk-to-reward and win-loss ratios whenever opportunities allow.

A good breakout strategy functions best when you combine it with technical indicators such as pivot, support and  resistance levels as well as technical formations such as head and shoulders; flags and pennants, etc. One of the prime advantages of breakout strategies is that they enable you to open trades at the birth of new trends.  These are great locations to identify because you can then initiate positions at the start of new major price movements with reduced risk exposure.

As already discussed, a breakout happens when a currency pair pierces through either the resistance or support of a restricted trading range. The amount of momentum required by price to accomplish such a task is usually sufficient to then propel it quite some distance in its new direction. This is why such events often create new trends or channels.

Research has demonstrated that the strongest breakouts occur when price surges out of technical patterns such as pennants and flags. Consequently, you should pay close attention to this important observation by attempting to exploit it as follows.

Locate situations where price has rebounded numerous times against its support or resistance. Next, assess if a pennant of flag trading pattern is in the process of being created.  If this is the case, look to activate a new trade as price will require significant momentum to force a breakout.

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.