Forex Breakout Strategies - What You Need to Know
Many newcomers often believe that a trading strategy should always work and under any market conditions. Also, some are poorly aware of what types of trading strategies exist and what are the features of trading for a particular type of TS. Knowing the features of each type of strategy, their advantages and disadvantages will allow you to develop more thoughtful and high-quality TS'ki. And today we will just discuss the features of building breakdown forex systems.
The breakdown of trend lines and important price levels means the appearance on the market of many large players with clear preferences in the direction of growth or decrease of one or another instrument. It is at such moments that they generate signals, helping to enter the market in the direction of large volumes. These are, as a rule, classic trading strategies tested by dozens of years of trading on various instruments.
The main idea embedded in breakdown trading strategies is that if the price has been in the range for a long time, then there will definitely come a moment of a forceful market decision and a breakthrough in a certain direction will occur. Therefore, for this type of strategy, it is quite critical to choose the very levels for breakdown and correctly filter out false breakdowns.
To fix a real breakdown, you need to correctly imagine the direction of the current trend, choose the correct levels, the breakdown of which can lead to a serious change in prices and determine the true breakdown of these levels in time. That is, we need less noise, which can distort our analysis and contribute to the wrong trading decision. That is why breakdown strategies work best on instruments with volatility not lower than average and on periods no lower than the hour, where there is not so much noise.
I do not say how true this will be, but let us agree within the framework of this article on the type of system to call the set of different systems identical in principle: trend, reversal, breakdown. That is, the type of trading system answers the question "What are we going to trade?". We call a class of a system a set of trading systems within one type that use a common approach to finding trading signals. Here the question more likely will come up - "How will we trade?". So, what classes can be inside such a type of system as breakdown?
Breakdown of the trend line
This is one of the oldest breakout trading models. On a growing trend, a line is drawn on ascending lows, on a downtrend - on falling maxima. As for all classes of breakdown strategies, it works well on the period from H1 and above.
Of course, the market is far from always trending and you can find a suitable trend line. And even if directional movement is found, the trend ones are quite subjective. Therefore, this class of trading systems is practically impossible to test - if you repeat the test several times in a program for manual testing, for example, in Forex Tester 3, you will most likely get slightly different results.
There are also quite a few indicators that identify trend lines automatically, but I have not seen a single one that would do it well.
Breakdown of support and resistance levels
This class of breakdown systems is also classic and one of the oldest. The entry signal for such a strategy should be not only the fact of a breakdown of a certain level or range, but also an analysis of market behavior near the borders of consolidation. In such strategies, stops are usually set at the last maximum or minimum level before the breakdown, and profit is taken in the amount of the amplitude of the consolidation range or the previous movement.
There are always support / resistance levels, on any asset and on all timeframes. A true breakdown of the level means a strong trading momentum, which makes it possible to take profits with minimal risk.
Fibonacci levels can also serve as excellent points for entering the breakdown. I did not distinguish such systems into a separate class, as these are also just price levels.
As a rule, they expect a breakdown of such Fibonacci levels as 38.2 and 50. Such a strategy will not necessarily be counter-trend, because the levels can also be built by pullbacks in the existing trend. To determine the basis for building levels, as a rule, the ZigZag indicator is taken. It helps to carry out all the construction on the machine, thereby avoiding subjectivity.
Breakdown of moving averages
The SMA and EMA lines, especially the standard set with periods of 20, 50, 100, 200, are the strongest price levels, and their breakdown means moving out of the average value zone and forming a new trend. In general, there are many ways to calculate moving averages, as our forum member Pavel888 wrote about in this article.
As a rule, a signal is generated when closing above the maximum or below the minimum of the breakout candle. Nevertheless, this basic class of systems in its basic version now brings quite a lot of false signals - markets have changed a lot with the advent of the phenomenon of online trading and the ability to carry out complex mathematical calculations literally instantly. Therefore, this class of systems, like the other classes, began to evolve. But unlike the other classes, it has turned into a completely new class of systems - a breakdown of volatility, which we will talk about a little later.
In fact, there is no need to use moving averages. You can very well work with such an indicator as Envelopes, taking deals in a purchase when the upper limit of the indicator is broken and vice versa for sales. In essence, this will remain the same class of trading systems, just a little modified.
Breakdown of the price channel
Historically, models of the breakdown of trend lines were followed by models of the breakdown of channels, which are based on the lines of support and resistance, calculated from past highs and lows. A trader buys when prices rise above the maximum of the last n bars (upper border of the channel) and sells when prices fall below the minimum of the last n bars (lower border of the channel). Channel breakdown systems are easy to program and very easy to understand. The simplest and most common example of a channel is the Donchian channel:
This channel is built on the highs and lows of a certain number of bars, in our example the last 60 bars. When this channel is broken, it enters the market.
The most famous example of a strategy of this class is the Richard Dennis Turtle System. Like all breakdown strategies of this class, it is very simple from the point of view of automation, as you saw when you wrote an adviser on this system. Nevertheless, the basic system shows good results until 90-95 of the last century, and without various modifications in the last twenty years, practically does not show profit, forcing traders to complicate and improve their TS.
As a rule, outputs for such systems are carried out during breakdown in the opposite direction to the open position. In the Turtle system, inputs are made during the breakdown of the 60-day Donchian channel, and exits with the breakdown of the 20-day channel. Protective stop loss orders are best set with reference to volatility, for example, according to the ATR indicator. The best results are shown by a coefficient within 2 - 3 ATR, depending on the instrument. Also, an alternative exit from positions with reference to the time of holding the transaction is often used. For example, all positions that were opened, say, 30 days ago, are closed. This approach helps when the system falls into lateral movement and hangs for a long time without a significant increase in profitability.
This class of trading systems is in fact profitable with due careful study of all elements of the system. The basic concept, as I said, ended the period of good profitability in the last century.
Another interesting option for building a price channel is by session or by range within certain hours. An example of this approach is the BigDog strategy. According to the rules of the strategy, a price channel is determined with a starting point 3 hours before the opening of the London session and an end point at the opening of the session. Thus, we get the price channel of the morning calm, on the breakdown of which we will trade.
The trading system does not show very high efficiency, but, with proper development, it may well serve as the basis for developing a strategy. To work on it, it is recommended to use short trailing - within 10-15 points. It is also advisable to try to take deals with channels not exceeding 20 points in height and avoid trading altogether with channels over 50 points.
Another option is to use the highs and lows formed, for example, during the Asian session. This approach is called the breakdown of highs / lows of trading sessions. The most profitable can be considered a breakdown of the highs and lows of the Asian session.
Another interesting option for building a price channel is to use the Ichimoku cloud:
Of course, this is not a grail, however, the approach is original, interesting, gives decent accuracy, good profitability and the ratio of risk to profit. With careful development, a trading system using this idea will be able to enter into transactions at the very inception of new trends and exit practically at their completion. I think very few large players use this technique, so it remains effective to this day. By the way, the author of this system is the well-known Swedish trader and analyst Lars Larsson, who claims to have achieved 80% of profitable trades in trading binary options from a modified strategy.
In the modified version, filtering of transactions using the Awesome Oscillator indicator is used, but for binary options, the number of profitable transactions is critical, not the ratio of profit to loss. Therefore, Forex can do without additional filtering, carefully considering transaction support, possible profit goals and loss limits. In fairness, it is worth noting that the author offers several different options for entering the position - the breakdown option, which we have analyzed, and the trend one, based on the reverse intersection of the lines forming the boundaries of the cloud.
The class of systems for the breakdown of price channels in tests works better than all other classes of breakdown strategies, despite the sometimes not very stable results.
Breakdown of volatility
Newer and more complex are volatility breakout models, where the points whose intersection causes a signal are based on volatility boundaries. The boundaries of volatility are located at some distance from the current price (for example, the closing price), and the distance is determined by the current volatility of the market: when it grows, the boundaries move farther from the current price, when it falls, the boundaries narrow.
Most often, the ATR indicator or Std Dev is used to measure volatility in this class of systems. So, to calculate the channel boundaries by standard deviation, the Bollinger Bands indicator was built, and the Keltner Channel on the ATR.
It is based on the following statistical idea: if the market moves in this direction more than expected from normal oscillatory movement (which is reflected in volatility), then, perhaps, there is an influence of some force, that is, a real trend. Buy - when the price rises above the limit of extreme volatility, sale - when falling beyond the lower border.
Many of the systems of this class were very popular in the late 80s, but are now quite rare. Personally, I was not able to get satisfactory performance from systems of this class, but perhaps I just can’t design effective filters to minimize false breakdowns. Or maybe the really modern market is not suitable for such systems. This assumption is also supported by many market researchers and their independent tests of a class of similar systems for the foreign exchange market.
Breakdowns on the Oscillators
This class of strategies is based on the breakdown of levels in the readings of one or another oscillator. An example of such a strategy is the rustling of morning stars for the H4 period, which is based on a breakdown of the levels of the Bill Williams Awesome Oscillator indicator.
Another option is the breakdown of overbought / oversold levels:
In this example, a breakdown of levels 100 and -100 of the CCI indicator is used. To determine the trend and filter deals against it, a moving average is used. For this class of strategies, it is not very important which oscillator to choose; the most effective way to determine the direction of the current trend is much more important.
The idea here is exactly the same as for all other breakdown trading strategies - if the price breaks the overbought or oversold level, it is very likely that this movement will continue.
To exit the position, as a rule, it is recommended to focus on the reverse intersection of the previously broken level by the oscillator.
Market entry methods
Breakout-based models may also differ by market entry method. Entrance can take place at the opening or closing of the day, or intraday entry using orders at the boundary levels. More sophisticated methods allow you to buy or sell at the border, i.e. try to enter the market on a pullback, when after a breakdown of a certain border prices briefly return to it.
The easiest option is to enter at the opening of a new candlestick, which allows you to test breakdown systems rather quickly and accurately, because for such options the movements that occur inside the candles of the selected timeframe are not important.
When working with stop or limit orders, it is very important to use tick data and testers that support changes in the spread during the testing process, because an inaccuracy of just a few tenths of a point can lead to the activation of a pending order or, conversely, to the omission of certain transactions. At the same time, it does not matter for what period the trading system is developed - it will still be very demanding on the quality of testing and the trading results of different brokers can radically differ.
That is why I personally act as follows:
That is, after breaking through candles of a certain level, the strategy implies, for example, placing a pending stop order slightly below the shadow of the breakout candle. Instead of placing an order, I just start tracking the level of the pending setting and as soon as the candle closes below it, I enter into a market deal at the opening of a new candle. This eliminates the need to use tick data and generally increases the reliability of the system, albeit at the cost of a bit of a delayed entry.
What is true breakdown
There is already a blog article on breakdowns and ways to enter deals. The classic definition of breakdown sounds simple: it is the price crossing a strong price level, after which it will be more likely to move in the direction of breakdown than returning. For a breakdown on the market, something serious must happen to move the price a certain distance.
It turns out that if the price approaches power levels, then four scenarios of behavior are possible:
- A rebound from the level without real breaking through the closing of the candle and the subsequent reversal;
- A rebound from the level without real breaking through the close of the candle and further consolidation near the level;
- A false breakdown of the level when the price comes back after a while;
- A true breakdown of the level, when the price is fixed at the borders of the broken level and continues to move.
It is believed that the more unsuccessful breakdown attempts occur, including false breakdowns, the more stable and significant a particular price level is considered, and the more market effort will be required to overcome it. For a reliable breakdown, at least 2-3 tests are necessary for a period of H1 and higher, and the more visible pullbacks, the more strong momentum should be expected in the direction of a new movement.
The following properties are attributed to true breakdown:
- Breakout candle closes above the level in case of breakdown up and below in case of breakdown down;
- The distance from the level to the closing price is desirable to have more than the average level of volatility. In other words, the price should close above or below the level at a distance not less than the ATR reading with a period, for example, equal to 7;
- It is also desirable that the price be behind the broken level for 2-3 candles without closing above the level for sales or lower for purchases.
A false breakdown is considered to be a breakdown at the price of some key level, followed by a quick (1-2 candles) reversal. The concept of false breakdown is directly related to market psychology. This is a manifestation of the “herd” reflex in the market, when small players try to catch the outgoing movement without serious analysis. As a result, purchases are made at the tops and sales at the lows.
Here are a few criteria for filtering false breakdowns:
- It is desirable to analyze the main trend and key price levels at higher timeframes than for entry. If the medium-term trend persists, and attempts to break against the trend are visible for a short period, then there is a high probability of ordinary speculation in order to collect the stops of market plankton, which constantly opens positions at highs and lows. The longer the analysis period, the more reliable the breakdown will be;
- If the direction on the medium-term direction of the current breakdown attempt is the same, then the chances of a “true” breakdown are much greater;
- In addition to the fact of the breakdown, it is worthwhile to analyze the candle patterns with which the breakdown was performed. A “true” breakdown very often forms a candle with a large body and small shadows, closed behind a key level. This means that the market is making serious efforts towards breakdown.
ADX Trend Filter
One of the problems when using breakdowns is that there is a tendency to extremely "sawtooth" trade in cases where the system registers a breakdown, but the real trend does not follow. One possible solution is to use a trend indicator to filter breakdown signals. Many traders use the popular ADX indicator.
Sifting out markets where there is no trend, sawtooth trading and long trades will slightly improve the results of the system. ADX is used to filter breakdowns according to White's research (White, 1993). A trend is considered to exist if the ADX calculated over the last 18 days reaches a new six-day high. Entrances are made only if there is a trend.
But is ADX filtering so useful? We already clarified this in the article, the link to which I gave above. I can only add that for breakdown systems, using ADX can still slightly improve the final result.
Advantages and disadvantages
The disadvantages of breakdown systems include the fact that breakdown models, like many other models based on following a trend, can enter the market with a delay, and sometimes it is so late that the movement has already ended. In addition, a position can be opened on a small price movement that does not allow a profit.
Another hypothetical problem, according to many traders, is that with the wide availability of high-performance computers, simple methods based on breakdowns no longer work quite well. It is believed that due to the wide popularity of breakdown systems, markets have adapted to them, and the efficiency of using breakdown systems has decreased due to an increase in price noise near the borders where breakdown based systems are placed. This circumstance makes these systems work unnecessarily often, especially in active markets characterized by high volatility.
A common property of breakdown systems is that they work better in long periods and in trending markets. A properly built breakdown trading system should solve the noise problem near the market entry points.
A separate problem is the channel width for the breakdown strategy. If the thresholds are set too close to current prices, a large number of false signals will be observed, which will lead to sawtooth trading - price noise will trigger orders in one direction or another. Since such movements do not represent real trends, transactions at best will not bring profit, striking a trader’s capital.
If the borders are spread too wide, then the system will conclude too few deals and enter the market too late for any important movement. With the optimal setting of channel boundaries, a theoretical system based on breakdown models can be very effective: frequent and small losses caused by the lack of continued movement or price noise will be offset by significant profits during large market movements.
To reduce the number of false signals and reduce the sawtooth trade, systems based on breakdown are sometimes connected with indicators that presumably determine the presence or absence of a trend in the market. If there is no trend, then the input signals generated by the system are ignored; if there is a trend, they are accepted for execution. The problem is that indicators do not always function accurately or do not manage to react quickly enough, falling behind the market and making the system work imperfect. Otherwise, any trader who applied them in combination with a breakdown or other model of following the trend would get rich very quickly, since the trading strategy would only enter into significant trends, conducting trading smoothly and stably.
In general, simple breakdown systems follow a predefined pattern and do not work well enough in today's highly efficient markets. This is in line with the assumption that there are less and less profitable trends. According to many traders, markets are becoming more “noisy” and counteracting trends, which complicates the work of the above methods. The exceptions are young instruments, such as the same cryptocurrencies, as well as low-liquid instruments, such as the USDMXN or USDZAR pairs.
There are many classes of breakdown-based systems, many trend filters besides ADX, and many additional ways to improve the proposed base classes of systems that were not considered here. I hope that I still managed to give you a good overview of the popular classes of breakdown based trading strategies and a solid foundation for your independent research.
Good luck and see you soon!