Breakout traders make up a significant portion of the overall forex market, breakout trading is very popular among traders in financial markets not just forex and is one of the oldest trading methods taught online and in books. Unfortunately as with lots of trading literature found online there are many myths around breakout trading which are simply not true.
Now breakout trading can be profitable during certain market conditions and I just want to say before we get into this article today that I’m not saying all breakout traders lose money, as with any strategy in forex trading people have got to find what works for them, if you trade breakouts and are successful in doing so then that’s fine, there’s absolutely no reason for you to read this article, however if you have not been successful trading breakouts then this article will maybe shed some light as to why the results have not been that great for you.
Where Do Breakouts Occur ?
Breakout traders are looking to trade in the direction of a movement AFTER it’s already begun.
The whole premise of breakout trading revolves around the idea that if the market breaks a level deemed significant by the breakout trader it has a higher chance of continuing in the same direction of which the break occurred.
Breakout traders will monitor many different types of levels in the market for places where they suspect a breakout will occur, the way they will enter into a breakout trade is usually by pending orders placed at these levels before the beak has occurred, I believe some people do enter the market using market orders as well when the market reaches the breakout point but I think overall the majority use pending orders.
One of the main places they tend to watch for breaks is support and resistance levels.
This resistance level on USD/JPY will have been identified by breakout traders as a place where a breakout is likely to happen.
They would mark the level on their charts and placed their pending orders accordingly, if you look to the far right of the image you’ll see I’ve put an arrow above one of the candlesticks
The reason why this candle is important is down to the fact that this is the candle where the actual breakout took place, when this candle closed above the resistance many breakout traders will have been entered into long positions either by the pending orders they had placed at the level or by using market orders when they saw the breakout occur.
You can see not long after the breakout occurred the market started to advance higher.
Another significant place they’ll usually be monitoring are recent swing highs and lows.
All the lines I’ve marked in the image above are places where breakout traders will have placed trades anticipating a breakout, notice how when the market breaks past these ‘levels’ there is usually some sort of movement in the opposite direction soon after, this happens for a reason which I will explain later but for now just familiarize yourself with what these level look like on your chart
Why Breakout Traders Lose Money
What I’m going to show you now is how breakout traders lose money in the markets.
This is why there tend to be retest at support and resistance levels in the market, it’s commonly accepted the reason the market returns to these levels is to give traders who missed the initial breakout another chance to get into the market, this is not the case, the main reason the market returns to these levels is to purposely make the breakout traders lose money and close their trades.
The bank traders want the breakout traders to close their trades because they want to place their own traders into the market.
In this example the bank traders want to place buy trades, so they need sell orders to come into the market to accomplish this. A large portion of these sell order will come from the breakout traders who went long closing their trades at a loss which results in them using a sell order.is down to them wanting to be able to place their own trades.
Now the market stops moving higher after the breakout occurs due to bank traders taking profits.
When the pending orders of the breakout trades get hit, there’s a huge influx of buy orders in the market, this is exactly what the bank traders want.
By the time the market has broken the highs the bank traders are already in significant profits on their trades and will be looking for a way to take some profits o the market, the only way they can do this is if they have fresh buy orders come into the market.
Why do these order come from ?
The breakout traders!
The buy orders from the breakout traders placing trades gives the bank traders the opportunity to take profits on their trades.
The three arrows I’ve put above the candles in the image signify where the bank traders are taking profits, you can see small wicks on each one of these candles, these wicks are showing you where the bank traders are taking profits, retail traders do not sell when they see the market moving up, so this selling must be caused by the bank traders.
Once all the buy orders from the breakout traders have been consumed by their sell orders from the bank traders taking profits off their trades the market begins to move lower.
This movement lower indirectly has the effect of causing the breakout traders to begin closing their trades as their profits start decreasing and their fear of losing money begins to take over whilst also causing some reversal traders to believe the market is going to continue going down in the direction of the trend, which causes them to also begin placing sell trades.
So far we have established that when the market moves down after a breakout two sets of traders start selling:
The breakout traders closing trades because their scared of not making any money.
And reversal traders who think the down move is going to continue.
Now with both sets of these traders selling it means the majority of the orders coming into the market will be sells, what do you think the bank traders are likely to do with all these sell orders.
Bank traders still see the potential to make even more money, they can easily place their buy trades due to the massive amount of sell orders now present in the market whilst also knowing where their profits are going to come from (the reversal traders).
When the down move is over and the market starts moving up again the reversal traders are the ones who are now under pressure to close their trades, they start to see their small profits disappear and out of fear close their trades, essentially handing their money over to the bank traders who were buying when the market was moving lower.
The example above is not a one-off case.
This process of making breakout trades lose money happens again and again in the market, it’s virtually identical for all places where breakouts occur in the market, I could have easily taken any random chart and found a place where breakout happened and you would see the same process described taking place.
Another way breakout traders typically tend to lose money is when false breakout occurs in the market.
These are very common in the forex market and are one of the primary techniques used by bank traders to sucker in unsuspecting breakout traders into taking an incorrect trade.
False breakouts usually happen when the banks have not been able to place their entire trade into the market and need more buy or sell orders to complete the position, using their money they will purposely make the market break a high or low which they already know breakout traders are watching, with the idea that most of them will either have pending orders already at the level anticipating a breakout or will place trade using a market order when they see the market break the level.
AUD/USD Daily Chart
The image above shows two really important things happening in the market, you can see I’ve labelled 1. and 2. on the image.
I’m going to start off by explaining whats happening at point 1.
At point 1. you can see there was a resistance level in place which at that point had been touched three times, meaning everybody in the market who has any kind of basic knowledge of support and resistance would have know for a fact that this was indeed a confirmed resistance level.
Breakout traders also know this, they’ll be anticipating a break higher due to them see that prior to this consolidation the market had made a swift up move.
The bullish candlestick below the 1. labelled on the image is the point at which the breakout traders identify a breakout taking place, many of these traders will of automatically been entered into long positions due to their pending buy orders placed at this resistance being hit, whilst many of them will have entered into the breakout using market orders.
With the resistance now broken, a lot of traders believe the market is set to continue moving higher, this doesn’t happen, instead we get a bearish candle which nearly manages to engulf the bullish candle seen immediately after the breakout, if you had access to a 2 day chart seeing these two candlesticks next to each other would make a pin bar.
This bearish candle seen after the breakout is the result of the bank traders selling into the mass of buying that took place when the breakout occurred, like I’ve mentioned before bank traders DO NOT place trades onto candles in which they want the market to go, if they want the market to go down they will not place trades onto bearish candles, it will always be done on the opposite candle, in this situation its the bullish breakout candle their selling into.
The next candle we see is a very large bearish candle, most of this candle is formed from people who placed buy trades when they saw the market breakout from the resistance level, these traders are now losing money, the pain threshold they have in their head as the maximum their willing to lose has been reached so a mass of selling begins to take place from them closing their trades.
You may remember at the beginning of this article I also said breakout traders tend to put their stops at recent swing lows and swing highs, in the image you’ll notice I’ve marked two swing lows with arrows, these swing lows are where the breakout traders will have put their stop losses, when the market hits the stops it will result in even more sell orders coming into the market.
Filling More Orders
Moving on I want to talk to you now about the point I’ve labelled 2. on the image.
The reason I’ve marked this point on the chart is to show you another example of how bank traders place even more trades into the market. (in this example it happens to be sell trades)
Looking at the candle with the arrow pointing to it you can see it has a wick on it which stops just at the point where the market broke the support level, the reason why it come back to this broken support is down to the fact that the bank traders want to place more sell trades onto the down move.
When the market breaks this support level breakout traders enter sell trades with the expectation of the market moving lower, initially this is what happens, the next candle turns out to be bearish and the market falls a bit lower, this lures the breakout traders into a false sense of security, they believe they have gotten themselves into a good trade, so they begin doing things like moving their stops closer to entry and taking profits.
On the next candle the market suddenly begins a small up move which ends with a candle with a wick on it, most of the breakout traders who sold when the market broke this support level will close their trades when they see this, to be in profit one day yet to see most of that mental profit (because they hadn’t actually made it yet) begin to vanish the next day causes these trades to close their trades out of fear of not making any money on the trade.
As we know to close their trade means they will have to use a buy order, buy orders allow the bank traders to place sell trades which is what ends up producing the wick on the candle.
If you look at the daily chart of USD/JPY on the 11th of December you’ll see another instance of this happening.
Breakout trading is really a method which looks good on the surface but is typically really bad in execution, it can be easy to be led astray when coming across strategies like this, the lure of quick profits entices people to believe that the method is a good one, unfortunately if you fail to understand how the market really operates then its quite difficult to know the differences between a good trading method and a bad one.