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Forex Course

146. Measuring The Strength of a Breakout

Introduction

When you can see the momentum of the market slowing down, you can soon expect a reversal breakout in any underlying currency pair. Knowing this info will boost your confidence to pull the trigger, and to scale your positions without any hesitation.  Conversely, to trade the trend continuation breakout, knowing the strength of the breakout is also crucial.

In this course lesson, we will learn how to measure the breakout’s strength and take appropriate action according to the information which the market represents.

Using The MACD Indicator To Measure The Momentum

MACD is one of the most common momentum indicators in the Forex market. There are many different ways to use the MACD indicator, and in our case, we suggest you look at the histograms of the indicator to gauge the market strength. As the price moves, if the histograms get bigger, it is indicating that the market momentum is increasing. In this case, we can expect a breakout in the direction of the trend. Conversely, if the histogram gets smaller, it means the momentum is getting weaker, and we can soon expect a reversal in the currency pair.

Buy Example

The image below represents a buy trade in the EUR/GBP Forex pair.

Please observe the first arrow in the MACD histogram. The upsurge lines indicate the strong trend in this Forex pair. When the price action goes above the breakout line with the rising histogram bars, it is a sign of a strong breakout. After the breakout, we took a buy-entry, and the pair printed a brand new higher high.

Sell Example

The image below indicates a sell trade in the CHF/JPY Forex pair.

The image below represents the entry, exit, and stop-loss placements. The price action breaks below the significant level with the rising histogram lines. This shows the sellers are real, and they are ready to make a brand new lower low. After our entry, prices went down, making a brand new lower low. Therefore, when the breakout indicates strong strength, we must go for smaller stops and hunt significant returns.

Using The RSI Indicator To Measure Market’s Strenght

RSI stands for Relative Strength Index, and it is a popular indicator which oscillates between the 0 to 100 levels. When the indicator reaches the 70 levels, it means the market is overbought, and a reversal is expected. When it reaches the 30 levels, it means the market is oversold, and an upside reversal is expected.

In this article, we are not going to use the RSI indicator, like how it is typically used. Instead, we will use the RSI divergence to measure the strength of the trend. A divergence is when the price moves in one direction, and the indicator moves in another. Divergence shows that the indicator is not satisfied with the price action, so in this case, a reversal should be expected.

Buy Entry

  1. Find out the divergence in a downtrend.
  2. Wait for the price action to break above the significant resistance level.
  3. Wait for the hold above the breakout level to confirm the breakout.
  4. Hit Buy.
  5. Place the stop-loss below the breakout.
  6. Go for brand new higher high.

The image below indicates the buying trade in the GBP/CAD Forex pair.

The image below represents our entry, stop loss, and take profit in this Forex pair. As you can see, the trend was down, but on the other hand, the RSI indicator failed to make the higher high. This indicates that the buyers are strong, and after any breakout, we can confidently go long.

Sell Entry

  1. Find out the divergence in an uptrend.
  2. Wait for the price action to break below the significant support level.
  3. Wait for the hold below the breakout level to confirm the breakout.
  4. Hit sell.
  5. Place the stop loss above the breakout.
  6. Go for a brand new lower low.

The image below represents the selling trade in this Forex pair.

As you can see, when the price action and indicator gave the divergence, it means the indicator didn’t like the upward spiral anymore. Also, the buyers are exhausted, and we can expect a strong downward reversal. Soon after the breakout, we took short entry and exited our position when printing the brand new lower low.

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Forex Daily Topic Forex Range

Hidden Wisdom Behind Range Measures

People coming to the Forex markets usually learned new vocabulary. The first special words they learn maybe are, margin, profit, risk-reward, and candlestick. Perhaps, afterward, they learn new concepts such as Volatility. Also, along with other technical indicators, they get to know one study called Average True Range. However, later, they forget about it since they usually consider it unimportant.

The Average True Range (ATR) is one way to measure Volatility. Volatility is, as we know, a measure of risk. Therefore, ATR can be used as an estimate of our risk. This measurement is essential for us as traders, especially if we are trading on margin. And I’ll explain why.

 

What tells the Range?

A range is a measure of the price variation over a period of time. It is measured between the High and the Low of a bar or candlestick. For instance, the range of figure 1 below (a 4H chart) is 357.9 points. If each point/lot were worth $1, a short position started at the Low of the bar would have lost $357.9 in four hours on every lot traded. Conversely, a long position would get this amount of profit.

True Range

True range is similar to a normal Range, but it takes into consideration possible gaps between bars. That happens a lot in assets that do not trade all day. Not always the close of a session matches the open of the next one. A gap may form. A True range accounts for that by considering gaps as part of the range of the bar if the gap is not engulfed by the range.

Average True Range

As we can see, in the figure above, every bar’s range varies depending on the particular price action on the bar. Some bars are impulsive and move considerably. Other bars are corrective, and their range is short.

Therefore, to measure the average price range an average is taken, usually, the 14-period, although traders can change it. Below we show the 10-bar ATR of the Bitcoin.

On this figure, we see that the ATR gets quite high at some point on the left of the figure, and it slowly decreases in waves. That is normal. Assets move in a series of increasing and decreasing volatility waves, which describes the interests and power of buyers and sellers.

Average True Range and Risk.

Retail traders usually have small pockets. The first measure a retail trader should know is how much his account would endure in the event of an adverse excursion.

As an example, let’s examine the EURUSD daily chart. Observing the 10-ATR indicator in the chart below, we see that the maximum level on the chart is 0.01053 and the minimum value is 0.00664. Since we want to assess risk, we are only interested in the maximum value.

Let’s assume that we wanted to trade long one EURUSD contract at $1.1288 and that, on average, our trade takes one day to complete. How much can we assume the price would move in a single day?

If we take the 0.01053 as its daily range value and multiply it by the value of a lot ($100K) we see that the EURUSD price is expected to move about $1,053 per day. We don’t know if that will be in our favor or not, but from the risk perspective, we can see that to be on the safe side we would need at least $1,053 of available margin for every lot traded.

If the average trade, takes 4 or 8 hours instead, we should set the timframe to 4H or 8H and proceed as we did with the daily range.

For not standard durations, we could use the following rule: For each doubling in time, the average range grows by a factor of the square root of 2.

That is handy also to compute the right trade size. Maybe we do not have the required margin level, but just one fourth. Thus, if we still wanted to trade the asset, we should trim down our bet size to one-quarter of the lot.

How much time our stop-loss will endure?

Based on ATR figures, we could assess the validity of a stop-loss level. If the stop-loss size is too short compared to the ATR, it might be wrongly set.

What profits to expect?

We could assess that as well, on average, of course. If the dollar range of an asset is $1,000 in a 4-hour span, we can expect that amount on average in four hours, and $1.410 (√2 * $1,000) on an 8-hour lapse.

Deciding which asset to trade

We could use the True Range to assess which asset is best for trading. Let’s suppose, for instance, that you are undecided about trading Gold (XAU) and Platinum (XPT). So let’s examine them.

Gold:

Spread: 3.2

$Spread cost: $32

Digits: 2

contract size: 100

MAX Daily ATR: 16, $ATR: $1600

Spread cost as Percent of the daily range: 2%

Platinum:

Spread: 12.9

$Spread cost: $129

Digits:2

Contract Size: 100

Max Daily ATR: 22, $ATR $2,200

Spread cost as Percent of the daily range: 5.86%

After these calculations, we can see that it is much wiser to trade Gold, since the costs slice only 2% of the daily range, while Platinum takes almost 5% of the range as costs before break even.