In the forex market, there are always occasions when there is low volatility and little activity on the part of traders. This is like the calm before the storm, as traders are simply sitting on the sidelines waiting for major news events to give them some direction on how to trade the market. When this happens, the price action of the currency pairs being traded may experience a dramatic surge in activity, leading to possible movements that may burst out of the narrow ranges in which they previously traded. This is colloquially known as the breakout. But what truly is a breakout?
At any time, there are price areas that function as support and resistance. These are areas where prices find it hard to either go below, or go above. Support and resistance zones provide boundaries on price action. During periods where there is a lull in activity, the price range between support and resistance is quite small. Support and resistance can be formed by trend lines used to join the lows and highs of price action. They can also be formed by pivot points, as well as upper and lower boundaries of chart patterns.
But what usually happens is that when major news hits the markets, institutional traders adopt a bias and increase their trading activity, causing the price action to move out of these boundaries. These may be trading opportunities too for the retail trader. But the questions that must be answered are:
- What is a breakout?
- What is a fakeout?
- How does a trader may recognise a breakout?
Whenever the price action bursts through a defined area of support and resistance, there is always a tendency for the price to want to go back to where it just came from. If price burst through a resistance and manages to close above that resistance, or if price goes below support and closes below that support, these two scenarios constitute a breakout. This is because the forces that forced the price action out of the two boundaries was strong enough to keep the price out of the boundaries, with the result that the price will continue to move in the direction of the breakout. Usually a broken support now becomes a resistance, while a broken resistance now becomes a support. Future attempts of price to return to where it came from may not be permitted by the broken key levels.
Sometimes price may seem to have moved out of the boundaries of support and resistance, only for the price action candlestick to go right back below resistance or above support to close within the boundaries. This is merely a fakeout and does not constitute a breakout. Many traders are deceived by the initial price burst and may decide to trade with it. This might be a bad practice which may lead to problems. Once the candle closes and you compare the closing price to the boundaries of support or resistance that you may be given an indication if the price action was a breakout or a fakeout.
The snapshot demonstrates a breakout and two fakeout situations. We can see the green dotted line, which was the S1 pivot point, and the purple line which is the central pivot. The first fakeout candle appeared to have broken the S1 pivot line, but retreated and closed below it. The breakout candle actually closed above the S1 line, paving the way for price to move upwards to the central pivot. Here, the candle merely moved above the central pivot but did not close above it (fakeout), and the price retreated from there.