A Breakout Trading Strategy

 Breakout trading is presented everywhere as an effective trading strategy and has been a part of the trading systems of many of the world’s most successful traders. Does trading breakouts work in Forex, and if so, in which currency pairs? What are the best ways to trade breakouts when they set up, where are the best entry and exit points? Read on to discover new research on Forex breakouts, and how you could use them to become a more profitable trader. 

What Is a Breakout?

A breakout is essentially when the price of something reaches a new high or low that it has not traded at for some time, after being contained within a relatively narrow price range during all or part of that period. This basic type of breakout is usually called a “horizontal breakout”.

For an example, check out at the daily price chart of the S&P 500 Index from 2 July 2021 shown below. The daily candlestick that day (shown on the far right of the chart) rose to a new all-time high price, but you cannot really call this a “breakout” as the price had already been smoothly flowing upwards and making new record highs for six days previously.

No Breakout: Price Already Rising

The real breakout here happened six days earlier, which we can determine by seeing where the range was which contained the price for some significant time and drawing horizontal lines at the high and low of that range. The price broke out with the daily candlestick above the up arrow in the price chart below.

A Valid Breakout: Break Above Price Range

There is another type of breakout: a breakout beyond a trend line forming the boundary of a Forex candlestick pattern. For an example, in the price chart below, the EUR/USD traded within a symmetrical rising price channel for twelve consecutive days, before making a bearish (downwards) breakout, which is also known as a breakdown, on the thirteenth day. The day of the breakdown is marked by the downwards arrow in the chart.

Trend Line Breakout

You can see the breakdown was made by a strongly bearish downwards candlestick which closed right by its low. When a breakout candlestick closes near the edge of its price range in the direction of the breakout, this can be a positive sign that the breakout will continue run for at least the next candlestick. It did in this case, with the price eventually moving down by more than 250 pips over the next sixteen days. However, breakouts from trend lines can be difficult for beginner traders to master because trend lines are very subjective and are drawn much more effectively by experienced traders.

Horizontal breakouts are especially attractive to traders.

Any day that the price breaks to a new long-term high or low generally in a market has a positive expectancy to continue in the same direction, the odds are most favorable at the time when the breakout begins. This point of entry also offers the best potential reward to risk ratio.

Typically, a breakout trader might trade the breakout shown above by putting a buy stop order 1 point above the breakout candlestick for entry, and a stop loss order 1 point below the low of that candlestick (shown by the red horizontal line within the price chart below).

Typical Breakout Trade Entry and Stop Loss Levels

Alternatively, the entry may be taken at the close of the breakout candlestick, without waiting for the high or low of that candlestick to be broken the next day.

Breakout trading strategies have been used by traders since the earliest days of market speculation, perhaps most famously by Richard Dennis and his “turtle traders” who made spectacular returns in the futures markets in the 1980s using a simple breakout strategy. However, breakout strategies are often misunderstood and oversimplified, so it is worth taking a deep dive into the pros and cons of trading breakouts, and what breakout traders can realistically expect to happen with breakouts in Forex and other speculative markets. It remains a profitable trading tool, but it is not for everyone, and can lead to disastrous losses if used incorrectly.

Pros and Cons of Breakout Trading Strategies

The most important pro with breakout trading strategies is that they have been proven to be profitable over many years in diverse markets, as they are all trend trading strategies. If you trade a breakout in the direction of the breakout, you are trading with the trend, and you are entering with positive short-term momentum, both of which boost the chances of a profitable result from the trade. Another great thing about trading breakouts is that you do not need to be an expert trader to follow a basic breakout strategy: if a trading strategy says, “go long at the close when a daily candlestick makes the first 50-day high price seen in the last 10 days”, all you need to be able to follow that entry rule is the ability to count to fifty and eyeball a price chart! You don’t even necessarily need to use any technical indicators in breakout trading, except the ATR and maybe momentum indicators, to be successful trading in this style.

The cons of breakout trading strategies mostly come from the fact that a large majority of trade entries based on breakouts, even stronger breakouts on higher time frames, result in losing, break even, or very small winning trades. The net profit comes from the few breakouts that do very well. This fact can put a big psychological strain on breakout traders, as long losing streaks and account drawdowns will inevitably happen, making it difficult to keep pulling the trigger when the next breakout setup comes along. This also means that if you miss a single trade, and it turns out to be one of the rare big winners, your profitability can be seriously dented, so precise and timely trade execution is vital. The other big con is money management: as breakout traders need to survive long losing streaks, it is important that they trade small relatively to their account size.

The Best Forex Breakout Trading Strategies

So, what breakout trading strategies work in Forex? The first thing to understand is that if you apply any rules-based breakout trading system to lots of Forex currency pairs and crosses over the long-term, you will almost certainly lose money. This is because the only currencies which have exhibited sufficiently consistent trending behavior over recent decades are the U.S. Dollar and to a lesser extent the Euro, and arguably the British Pound. To be profitable over the long term, you need to be very selective in either the currency pairs you trade, or the breakout setups you choose to trade. Breakouts can be an effective tool in your trading arsenal, but the truth is that breakouts in Forex are not as effective as they are in other asset classes such as stock market indices and commodities.

Following the Trend – A Breakout Trading Strategy

Let’s start by examining the breakout trading strategy presented by asset manager and trend-following expert Andreas Clenow in his book “Following the Trend”. Clenow claims that this simple strategy to identify a good breakout trading setup has been the basis of almost all professional fund trend-following strategies for many years:

• Enter a new long trade when the price closes at a 50-day high closing price and the 50-period moving average is above the 100-period moving average.

• Enter a new short trade when the price closes at a 50-day low closing price and the 50-period moving average is below the 100-period moving average.

• Position sizing should be based on the 20-day Average True Range (ATR). Clenow suggests that in a widely diversified strategy across major asset classes, 0.25% of account equity should be equal to the 20-day ATR.

• Only have one trade in one asset open at any time. There is no scaling in or out.

• The stop loss should initially be set at 3X the 20-day ATR and should then be trailed from every higher daily closing price made until the trade is finally stopped out by reaching the stop loss. All trade exits are triggered by the stop loss.

If we back test this strategy against a wide range of Forex currency pairs and crosses over a long period such as the 20 years between 2001 and 2021, we find that it has only been significantly profitable in the EUR/USD and USD/JPY currency pairs (even if we ignore the costs of overnight swap fees) and has produced a loss in almost every other currency pair or cross.

The strategy outlined above can be improved to give better historical results in the Forex asset class in four ways:

1. Only trading EUR/USD and USD/JPY, which are the two most liquid and most traded currency pairs, which probably contributes to their trending attributes relative to other pairs and crosses. These two currency pairs in 2021 accounted for 41% by traded volume of the entire global Forex marke (htt1)t.

2. Tightening the stop loss from 3X ATR (the only breakout trading indicator you really need) to 1 ATR or even less. The tighter the stop loss, the higher positive expectancy achieved over the long term, although this of course lowers the win rate. Clenow’s strategy is designed for futures and not retail spot Forex. In retail Forex, brokers typically charge an overnight financing fee every day, so holding positions open for very long periods causes a significant drag on profitability. A tighter stop loss will of course produce a lower percentage of winning trades, but the average winner will be much bigger due to the superior reward to risk ratio.

3. Using a time-based exit of 8 days rather than a trailing stop. The choice of 8 days rather than another number is curve-fitted: I know that 8 days gave the best results overall. I use it to demonstrate the viability of the strategy, as this exit condition is applied to every trade equally. A time-based exit can be usefully applied in a long-term back test to effectively evaluate a trading strategy.

4. Using a breakout trading setup where Clenow’s entry conditions are filtered: the high or low closing price must be the first made in the past 5 trading days.

Below are the results (not accounting for overnight financing/swap fees) of a back test applied to the EUR/USD and USD/JPY currency pairs between August 2001 and 2021, a long period of 20 years, involving 214 trades:

This breakout trading strategy would have produced excellent results, although the time-based exit of 8 days is curve-fitted. Note how the tighter the stop, the higher the average result per trade. You could have secured an amazing result of more than doubling your money risked per trade while losing more than 90% of all your trades – but could you have executed this? The psychological strain and the long losing streaks would have been extremely difficult to cope with. Another issue is that if you are using a money management strategy of risking a percentage of account equity, the long losing streaks could make the winning trades notably smaller, so there is a tradeoff to be made between expectancy and win percentage. One potential solution would be to scale out in equal measures of the position size by using four different partial stop losses at the different ATRs shown in the table above, which hopefully would get you some of the best of all worlds.

Lack of Strong Forex Trends 2016 – 2021

Before you get too excited at these back test results, although this breakout trading system has been very profitable over a period of twenty years, over the past five years from the time of writing, it has been slightly unprofitable, although this is only due to the USD/JPY currency pair’s performance. If the strategy had been traded only with the EUR/USD currency pair, it would have been profitable during this period. The 5-year back test results from 2016 to 2021 are shown in the tables below:

Note that the results of this 5-year back test also show higher profitability with tighter stops, correlated with lower win percentages. These are essential features of breakout trading strategies.

Should You Trade a Forex Breakout Strategy After a Period of Poor Performance?

By now you are probably asking yourself how a strategy that performed so well for 15 years could produce a loss over five years, and whether you should trade it. Here are some answers:

1. The loss over the past 5 years is relatively small, far less than the positive result of the previous 15 years. This is an indication of a robust strategy despite the long losing streak.

2. This does not have to be the only strategy you trade – it could be a strategy that you trade on a small scale alongside other strategies that make more timely profits. If you are aiming to make money trading over the next 10 years, does it matter if you must wait 5 years for the profit to arrive?

3. You could use fundamental analysis instead of only technical analysis to filter trades, you do not have to take every breakout setup. Remember, breakouts are only useful if they produce a strong trend move lasting for several candlesticks. One of the reasons why the USD/JPY pair did not trend well between 2016 and 2021 is that the monetary policies of both the relevant central banks became convergent, and the Forex market came to see both currencies as “safe havens”. If you see there are reasons why a certain currency pair is unlikely to trend over the longer term, it is probably a good idea not to trade breakouts in that currency pair!

Customizing a Breakout Trading Strategy

Variations on this trading strategy can be improvised quite easily. If you know that when one of these major currency pairs is breaking out to new long-term highs or lows, it tends to continue often enough to give an expected profit on average, exact entry and exit points are relatively unimportant and subject to debate and improvement.

Regarding entry points which would tell you where to buy breakouts and where to short breakdowns, the main debate is between traders who prefer to enter at the close of the breakout candlestick (as in this strategy), at the break of its high or low on the next candlestick (which may indicate strong momentum) or following a pull back (also known as a price retracement). There is some evidence that in Forex, waiting for a pull back after the breakout for an entry point produces better overall results – for example, if there is a strong bullish candlestick making the breakout, followed by a small bearish candlestick, this can be a great entry point. Another approach would be to identify recent broken resistance and to put a limit order there as an entry so that when the level is retested upon a pullback following the breakout, you open a new trade. This can be painful however, as often if there is good demand at that level, the price just misses it before taking off in your desired direction, and the winning trade leaves without you. The problem is that the best entry points are usually where short-term momentum begins moving in the direction of the trade, so a solution here could be to wait for this set up on a daily chart, and then drill down to a short time frame and enter where the momentum begins to turn there.

In the back test shown I used a time-based exit. There are probably better ways of planning exits from breakout trades, but these can be very difficult to execute successfully, especially for less experienced traders. It stands to reason that most of the profits are made from the big winners, and that big winners usually take several candlesticks to reach that big win, but it is important not to use an overly long period. For these reasons, a realistic time-based exit can work well, but sometimes this method gives back too much floating profit. If so, some type of trailing stop can work better. The beauty of a trailing stop is that it can be a “set and forget” method that can be executed very easily. Another method involves leaving a winning trade until it reaches a certain amount of floating profit, say 2X ATR, and then implementing a trailing stop, or maybe just setting the stop loss to breakeven. Finally, an experienced trader may be able to start judging the price action once enough floating profit it on the table to justify looking for an exit, but even experienced traders struggle to beat a time-based exit method. A solution might be to scale out of the trade at a certain number of days after entry, then more at the next day, etc. which should reduce the risk of getting the number of periods for an exit “wrong”.

Which Breakouts are More Likely to Succeed?

If you are interested in trading Forex breakouts in a more discretionary way, whether by choosing which breakouts to trade, or by varying your position sizes per trade while following a mechanical breakout trading strategy depending upon how good you feel about each trade setup, it will help you to be aware of the common components of the more successful Forex breakouts.The presence of any of these factors at the start of a Forex breakout will increase its likelihood of success:

1. Breakout is in the Direction of the Higher Timeframe’s Long-Term Trend

2. Supportive Fundamental Data

3. Central Bank Policy Change

4. Increase in Volume – this can be hard to measure in Forex, unlike other markets, because of the absence of centralized exchange data. However, volume data is available from equivalent currency futures exchanges, and from some Forex brokers, so it can be done.

5. Smaller Sized Breakout Candlestick (for example less than 1X ATR)

Pitfalls of Breakout Trading

Most of the pitfalls of trading breakouts in Forex come from the fact that to do it profitably, you need to use relatively tight stop losses, and be ready to endure a low win percentage which of course causes long-term losing streaks. This can create very strong negative psychological pressure which tends to make it hard to continue trading this way. Overall profitability in trading breakouts comes from a small number of big winning trades, so missing only a single trade can make the difference between the breakout strategy winning or losing over an entire year. For these reasons, breakout trading can be too difficult for most normal personalities. This issue was well documented by the turtle traders of the 1980s, and by Jesse Livermore at the dawn of technical analysis in the early 20^th century. Both traded breakouts, and their memoirs are full of descriptions as to how only exceptional personalities could endure the psychological pressures of trading in this style sufficiently to execute breakout trading strategies consistently. In “Reminiscences of a Stock Operator” Livermore relates that most speculators thought his “buy high, sell higher” breakout trading style in commodity trading was very strange. Several of the turtle traders have written that to make money trading breakouts, you had to trade in a way that lost money most of the time, and many of the trainees simply could not do this even when they were paid to execute simple rules written right in front of them with someone else’s money.

Aside from the heavy psychological strain of executing a breakout trading strategy over the long term, there is a phenomenon of inexperienced traders learning about breakouts and seeing them everywhere, on all time frames, and trading them all. This is a very quick way to blow your trading account! If you have a good reason to be looking for a long trade in AUD/USD, for example, you might be able to justify drilling down to a 5-minute chart when the New York session begins and entering a 20-period breakout trade there. Yet breakouts in Forex tend to be widely and highly overrated, and if you go and trade breakouts everywhere on all pairs and all time frames you will certainly lose money and probably your entire account. Breakout traders must be much more selective than this to have a chance of success.

A final pitfall is the fact that the most robust money management strategy is risking a fixed percentage of account equity per trade. Theoretically, this means you can never lose everything. It also means that you win bigger when you have been winning recently and lose smaller when you have been losing recently. Unfortunately, this also means that if you trade a strategy with long losing streaks composed of many trades, when your big win finally comes, it will not count for as much as it should. Over the short and medium terms, your equity curve will depend greatly on luck: whether your first big win is your first trade or your fiftieth trade. This is a major reason why trading breakouts should probably not be your only Forex trading strategy. Some traders try to compensate for this by trading consistent position sizes regardless of their account drawdown, but this is very problematic: where do you stop, and how deep an account drawdown will you tolerate to achieve this?

Breakouts in Stocks

As most Forex brokers today offer trading in major stock market indices and even individual stocks, it is worth noting that breakout trading strategies can usually be used more effectively in stock markets than in the Forex market. This is mostly because stock markets, unlike the Forex market, have a directional bias to the long side, tending to rise in value over time. You might be able to buy the S&P 500 Index on a breakout and watch it go up for years or even decades without once coming back to the entry point and wiping out your floating profit: that is extremely unlikely to happen with any currency, especially not a major one. Stock markets also generate centralized volume data which can be used to identify higher-probability breakouts where volume is rising.

In stock markets, breakouts usually do not work so well on the short side (as strongly bearish moves tend to originate from sudden drops from highs rather than technical breakouts from lows) but can be used very profitably on the long side. A discussion about trading breakouts in individual stocks is beyond the scope of this article, but we can examine how the breakout trading strategy I outlined earlier has performed over a twenty-year period from 2000 to 2020 with a time-based exit of 200 days (approximately equivalent to a year) in the S&P 500 Index, as a long-only strategy.

Although the time-based exit applied here is much longer, this is doable in a bull stock market, and the long-term results were excellent. In Forex, holding periods must be considerably shorter. Note that just as in the Forex back tests shown earlier, as the stop loss used gets tighter, overall expectancy rises, while the win percentage decreases.

Be aware that holding trades in a stock market index open for 200 days will be costly at a retail CFD brokerage due to overnight financing/swap charges. This strategy is much more suited to the micro futures or ETF markets.

Final Thoughts

Trading Forex breakouts can be a profitable and technically easy mechanical trading strategy if trade entries are restricted to long-term breakouts or breakdowns in the most major currency pairs only, such as the EUR/USD or USD/JPY currency pairs. However, there will inevitably be long losing streaks and significant drawdowns as part of applying this strategy, so it is best implemented alongside other trading strategies simultaneously. Breakout trading tends to be more profitable in other asset classes such as stocks and commodities. Breakouts can be overrated in Forex, and mostly have no meaning on shorter time frames unless there is a significant development in the highest time frame.

In Forex, a discretionary breakout trading strategy may make more sense than a purely mechanical one if fundamental analysis, and maybe advanced technical analysis, is used as a filter. Beginner traders will probably find this challenging. A good place to start would be by only taking trades in the direction of the currency of the central bank which has a more hawkish monetary policy than its counterparty on the other side of the trade.

Long-only breakout strategies can work extremely well in bull markets and tend to work better in major commodities than in major Forex currency pairs.

Breakout strategies applied indiscriminately to a wide range of Forex currency pairs will inevitably lead to long-term losses, especially if they are applied on shorter time frames regardless of the long-term trend. However, short-term breakouts can be a useful tool even in day trading in the hands of an experienced trader.

FAQs

Is breakout trading profitable?

Breakout trading is profitable over the long time if diversified across asset classes but is not profitable in Forex if applied beyond the major currency pairs.

How do you confirm breakouts in trading?

Breakouts are best confirmed by a strong initial performance, supporting fundamental analysis, and rising volume.

How do you use a trade breakout strategy?

Wait for a market to break out beyond long-term support or resistance and enter a trade in the direction of the breakout with a relatively tight hard stop loss.

What causes a stock breakout?

Stock breakouts are usually caused by a strongly rising broad stock market, coupled with a strong performance by the company.