Trade Breakouts - Ed Ponsi
Guest Author Profile: Ed Ponsi
Ed Ponsi is the President of FXEducator LLC and is the former Chief Trading Instructor
for Forex Capital Markets (FXCM). An experienced professional trader and money manager,
Ed has advised hedge funds, institutional traders, and individuals of all levels
of skill and experience. A sought-after public speaker, consultant, commentator
and writer, Ed has appeared in numerous seminars, trading magazines, and live broadcasts,
and is a frequent contributor to trading websites.
Introduction:
When trading intraday breakouts, or when engaging in any type of trading for that
matter, it is important for the trader to use every type of advantage possible.
In all forms of trading, no matter if the vehicle is the equity, futures, or the
forex market, there are many instances of false breakouts. In order to reduce the
negative effects of these events, let's take a closer look at intraday breakouts
and how to trade them.
Triangles before breakouts:
Ascending and descending triangles create excellent breakout patterns, because the
pattern itself establishes a directional bias for the trade. An ascending triangle
is formed by a combination of diagonal support and horizontal resistance; a descending
triangle is formed by a combination of diagonal resistance and horizontal support.
In the case of an ascending triangle, the bulls are gaining strength and buying
at higher and higher levels, while the bears are merely trying to defend an established
level of resistance. In the case of a descending triangle, the bears are gaining
strength and selling at lower and lower levels, while the bulls are merely trying
to defend an established level of support.
When trading ascending or descending triangles, the trader can gain an edge by looking
to the direction of the currency pair prior to the formation of the triangle pattern.
Ideally, we search for situations where the triangle and the prior trend are in
agreement, directionally speaking. This is because it is not unusual for currency
pair to trend, then consolidate, and then resume trending. The directional bias
of a triangle is to break the horizontal support or resistance, and if the pair
was trending in the same direction prior to the formation of the pattern, the trade
becomes all the more compelling.
For example, on the hourly chart of the EURUSD pair, we see the formation of a descending
triangle.
Figure 1: A descending triangle on the hourly EUR/USD chart.
The first thing the trader needs to ask is, what was the trend prior to the formation
of the triangle? If we take a longer view of the pair, we can see that the pair
has been trending steadily lower.
Figure 2: Descending triangle harmonizes with the prior downtrend.
It's important that we use the power of this trend to our advantage, to reduce the
occurrence of false breakouts. As a general rule, traders should always trade with
the trend, and never fight the trend. It is essentially the difference between swimming
with the tide or against the tide, and traders that fight against trends often regret
their actions.
Time of day & volume:
Another edge that we can put to use when trading intraday breakouts is the time
of day. Perhaps you are familiar with the trading axiom that a breakout is considered
significant if it occurs on high volume, and is considered less significant if it
occurs on low volume. While forex traders are not able to easily access accurate
volume figures, we do know that trading is not equally liquid at all time of the
day, and there are certainly times of day that generate more volume than others.
Let's take a closer look at the forex trading day to see how we can use this to
our advantage.
When we're dealing with a vast, liquid market like the Forex, it's important to
understand which times of day are the most active and most liquid. Because this
market follows the sun around the world, trades take place literally all day and
night. Let's take a closer look at the Forex trading day, to gain a better understanding
of the market and of its optimal trading times.
The Forex trading day is considered to begin at 6:00 PM Eastern U.S. time. Because
Forex trades 24 hours per day, the trading day also ends at 5:00 PM Eastern. Why
is this particular time used? Consider that when it is 5:00 PM on Sunday in New
York, it is monday morning in places like Australia and New Zealand. Overall, volume
is low at this time of day because the three biggest Forex volume centers – Great
Britain, the United States and Japan – are mostly inactive at this time. However,
the Australian dollar and the New Zealand dollar (also known as the "Kiwi") may
see some price activity during these hours.
A few hours later, around 7:00 PM Eastern U.S. time, Japan awakens and the Forex
markets begin to stir. Japan is the third largest Forex trading center, and comprises
about 10% of all Forex trading volume, as many major banks have offices in Tokyo.
The Japanese Yen is particularly active at this time, especially vs. the Euro, the
U.S. dollar, and the Great Britain pound. Most of the volume occurs during the early
part of the Japanese session, and the liquidity lessens considerably as the trading
day continues.
As the Japanese trading day winds down around 3:00 AM Eastern U.S. time, European
markets open for business, and the London trading day begins soon afterward. Great
Britain is by far the most important and influential Forex trading market in the
world. The dealing desks for many of the world's major banks are run from London,
and the market is responsible for roughly 30% of all spot forex volume. London tends
to be the most orderly forex market due to its tremendous liquidity.
About midway through the London trading session, U.S. Forex traders come to life.
New York is the second most important market in Forex trading. New York trading
is very liquid and accounts for about 20% of the world's total forex volume. Trading
is especially active early in the New York session, as the London session is still
ongoing. U.S. Economic news releases often occur early in the New York session,
and can cause a tremendous amount of volatility.
Trading often becomes choppy after midday in New York as the London market winds
down, and liquidity and volatility begin to dissipate. By mid to late afternoon
New York time, London traders have gone home for the day, and it is late at night
in Japan. New York traders, while still active at this time of day, have already
finished with the bulk of their trading. Friday afternoons in the U.S. are generally
the least active, because for much of the trading world, it is already Saturday.
Finally, as the U.S. markets close, a new trading day is just about to begin in
the western Pacific, as the Australian and New Zealand markets begin to stir, starting
the process once again. The cycle continues all week, with most dealing desks closed
from Friday afternoon until Sunday afternoon, when trading resumes.
A closer look:
Now that we have a greater understanding of the forex market's liquidity as it relates
to various times of day, let's see how this can affect our trading. Just like an
equity trader, I'll assume that a breakout that occurs at a time of high volume
is legitimate, and a breakout that occurs at a time of low volume is suspect.
For example, let's take a look at the daily chart of EURUSD. The pair had formed
strong support in the summer of 2004 at 1.2000, which is also a number that takes
on psychological significance because it is a large round number. In fact, the pair
could not close below 1.2000 and then trended higher, before returning to the same
area of support in the summer of 2005, when it cautiously hovered near 1.2000. Finally,
during the August 24 session, the pair suddenly tries to break support. However,
we can see in the five-minute chart that the break was short-lived, a classic example
of a false breakout.
Figure 3: False breakout below support on EUR/USD.
A trader who pays attention to the time of day would have noted that the break occurred
late in the Japanese session, a time of day that is notorious for low volume and
for false breakouts. Such a trader would have considered the timing of this event
to be suspicious and would have refrained from entering a trade.
One week later, on July 1, the pair tries to break the support level once again,
only this time the breakout occurs at approximately 1430 GMT
Figure 4: A true breakout below support.
At this time of day, the London session is ongoing, and the New York session is
well underway. As a result, this is a time of high volume and the trade is more
likely to succeed. The pair finally breaks 1.2000 and drifts as low as 1.1865 over
the next few days.
As we can see, there are steps we can take to alleviate the problem of false breakouts.
These are just a few of the subtle nuances that traders use to gain an edge.
Affiliation Disclaimer
The views expressed in this presentation are the views of the author and do not
necessarily reflect the views or policies of Interbank FX or its directors. Interbank
FX does not guarantee the accuracy of the data included in this presentation and
accepts no responsibility for any consequence of their use. Interbank FX and IBFX
® are not affiliated with any participating speaker or presenter, nor has this presenter
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