To better understand pullbacks and breakouts we first need to understand support and resistance. These are a reflection of supply and demand and are very illustrative of market psychology.
- Support: a price level where buying interest overwhelms selling interest, causing a pause in the decline, or a bottom.
- Resistance: a price level where selling interest overpowers buying interest, causing a pause in the rally or a peak.
Breakouts and pullbacks are based on the understanding that price often “tests” a certain limit multiple times. For example, a currency pair might reach a certain level that was rejected a few times before. Once the price manages to push through it, we have a breakout. See the example below:
As we can see in the EUR/USD example, the market kept on pushing the price up to the resistance point, until it eventually broke through it.
These types of breakouts generally turn the resistance into support, retesting the established horizontal level and continuing higher. The opposite will happen in downtrends when the price is attempting to break support levels.
Oftentimes, breakouts lead to explosive movements and that is why they are so profitable. The strength and speed of a with-trend Forex breakout is why it is so important to predict it.
Quick jumps in price will take you by surprise if you are unprepared and will be over before you ever had a chance to profit.
Keep in mind:
The idea behind trading the breakout is to enter a trade when the price “escapes” a tight range. When it does that, it often tends to keep moving in the same direction.
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