Trading Forex Using A Breakout System

This is an article from http://theforexarticles.com/2007/10/24/trading-forex-using-a-breakout-system/.

Trading forex breakouts is one of the more basic trading strategies, but nevertheless it can deliver excellent profits. Just because a system is easy to follow does not mean it cannot produce consistent profits as breakout trading is a method used by some of the most successful forex traders around.

It's based around the whole premise that if a currency pair is trading in a very tight range for a sustained period of time, then eventually it will break out of that range and more often than not it will continue moving in the direction of the breakout.

This means that to make consistent profits you need to firstly identify instances where a currency pair is trading in a narrow range, and then place buy and sell orders at or slightly outside the current range to catch the breakout when it happens.

Furthermore if you want to look for the optimum set-up then you can use technical indicators to help you. My own method is to use a weekly 30 minute chart displaying 15, 50 and 100 period exponential moving averages.

When the price starts trading in a narrow range and all three of these EMA's have flattened out and also currently lie within this range, then this to me is the perfect breakout set-up. Why?

Well because with all three EMA's flat, something's got to give. It's like a volcano waiting to erupt. Once the breakout occurs, you could get a very big movement because the longer term EMA (100) can trend for a very long time so you could get a big points haul if this EMA follows the price and moves outside of the current trading range.

As regards targets and stop losses, I personally use the current trading range to determine where I place my stops so if I go long at the top of the range, then my stop loss will be at the bottom of the range. This is only really an emergency stop as most of the time the breakout will follow through and not go anywhere near this stop loss. My target price is usually the same number of points away as the stop at the very least.

The best thing about this system is that it works pretty well across many different time frames, plus not only does it work well for trading forex markets but it's also an equally good system for trading other financial instruments as well.

Risk Aversion

There is a lot of talk about "risk aversion" in the financial markets these
days. It appears that when the markets go into free fall, risk aversion is
associated with the cause. Take this article as an example:

"SYDNEY, Jan 21 (Reuters) - The Australian dollar was on the defensive on
Wednesday after sliding to six-week lows as mounting concerns about the
global banking system hammered equities and drove extreme risk aversion..."

The following excerpt from Wikipedia explains what all this talk is about.

Risk aversion is a concept in economics, finance, and psychology related to
the behaviour of consumers and investors under uncertainty. Risk aversion is
the reluctance of a person to accept a bargain with an uncertain payoff
rather than another bargain with a more certain, but possibly lower,
expected payoff.

The inverse of a person's risk aversion is sometimes called their risk
tolerance (for a more general discussion of the concept, see risk).

Example:

A person is given the choice between two scenarios, one certain and one not.
In the certain scenario, the person receives $50. In the uncertain scenario,
a coin is flipped to decide whether the person receives $100 or nothing. The
expected payoff for both scenarios is $50, meaning that an individual who
was insensitive to risk would not care whether they took the certain payment
or the gamble. However, individuals may have different risk attitudes. A
person is:

• risk-averse if he or she would accept a payoff of less than $50 (for
  example, $40), with no uncertainty, rather than taking the gamble and
  possibly receiving nothing.
• risk neutral if he or she is indifferent between the bet and a certain
  $50 payment.
  
• risk-seeking (or risk-loving) if the guaranteed payment must be more
  than $50 (for example, $60) to induce him or her to take the certain option,
  rather than taking the gamble and possibly winning $100.

The average payoff of the gamble, known as its expected value, is $50. The
dollar amount that the individual would accept instead of the bet is called
the certainty equivalent, and the difference between the certainty
equivalent and the expected value is called the risk premium.

Buying on Dips and Selling on Rallies

In an uptrend, a trader would want to wait for a pullback/retracement to a low, a level of support, and then go long (back in the direction of the trend) with their stop placed just below a recent level of support. This would be referred to as "buying on dips". The oscillator that you mention, could be used to time the entry. For example, entering an uptrend off of a pullback, the trader could use Stochastics as it came from being below 20 and moving above 20 as a sign that momentum would now be in the direction of the trade.

In a downtrend, the strategy would be reversed and we would "sell on a rally".

Take a look at the chart below for a visual...


The USDJPY pair is in a downtrend on the chart so we would only be looking for selling opportunities. Each time the price action moves back up/retraces within the overall downtrend, it would be another opportunity to sell the pair. The stop would be placed perhaps 20-25 pips above the highest point that the pair had traded on that particular upswing.

Also note on the chart below how MACD shows crossovers to the downside indicating that momentum is behind each of the selling opportunities on the chart.

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Source: Richard Krivo, Power Course Instructor (strategist@dailyfx.co)

Opportunities Missed!

I entered into 2 Forex trades on 09-Jan-09 (short AUD/USD, and short USD/JPY). The technical justifications for these trades turn out to be accurate and the trades moved in the correct direction, as predicted. It produced profitable results; but, I just got out way too early!

I exited both these positions after less than a day of openning them and it made a meager A$93 of profit. Had I kept them until today (only 3 days later) I would have made 10 times more - a whopping A$900 in profit! Bummer!

I am kicking myself now and wondering why I got out... Actually, both currency pairs became quite volatile at the time of exit and I didn't want to lose the profit. So, it was the fear of losing money that made me close these really profitable positions (with the benefit of foresight of course).

Oh well, at least I made a bit of money. Nothing worst than losing money. Here are the charts.

Spot AUD/USD Daily Chart:

Spot USD/JPY Daily Chart:

• A lesson for the future is to stay in the trade if the technical justifications for entering the trade is still valid and the stop loss levels have not been hit.

Trading in the Bear Market

Given that stock markets everywhere around the world are pretty much in bear market mode now, I think it would be wise that any potential long position should be taken with great caution and only if there is a convincing case for it.

For example, instead of using the 35-week new high trading system to open a new long position in some stock, I might extend the period to say 50 or 60-week instead. This may ensure that any bullish reversal is confirmed and not just end up being a whipsaw.

I have seen stocks making making new 35-week highs over the last 18 months of the bear market, then immediately run out of steam and crash to make new lows. Logic would tell us that in a bear market, there is a higher probably that any bullish reversal is just a temporary retracement of the down trend.

Even if a long position is opened in current conditions, the position size should be less than usual, as to reduce the risk of trading a bear market.