Breakouts are one of the things you will see taking place all day in the forex markets. The majority of breakouts end up being false breaks which means the market doesn’t actually end up moving in the direction of the break and is simply a trap by the professional traders to lure breakout traders into placing trades in the wrong direction.
When a breakout does occur and the market moves in the direction of the break, commonly you’ll see the market return to the highs or lows of the breakout, touch them, then proceed to go off back in the direction of the breakout. Trading the retest of a breakout point is not a new strategy, it has been around since the first technical analysis books were released and is a method employed by traders all over the world.
Today’s article is going to be a small guide on how to trade retests of breakouts properly, a large number of people trade retests incorrectly because the rules provided to them by trading books and websites are not aligned with how the banks operate in the forex market. We’ll begin by looking at the reason why a retest occurs after a breakout takes place, then I’ll show you how to trade retests using a combination of zones and price action and give you a couple of really I’m important rules you must follow in order to trade the retests effectively.
What Are Retests At Breakout Levels ?
My understanding of a retest at a breakout level is where the market breaks out past a high or a low and then soon after returns to the breakout point and moves back in the direction of which the breakout occurred. Why this takes place in the forex market is down to the bank traders needing to fill more buy or sell orders in the market. Before the market breaks out from a high or low breakout traders will have pending orders placed at the levels ready for when the market inevitably breaks out, when the breakout finally comes the traders orders are executed and the traders are entered into their breakout trades.
The breakout traders spend a little bit of time in profit on their trades as typically the market will continue in the direction of the break for a small amount of time, the turning point comes when the bank traders begin to take profits off their own trades, their profit taking is what will cause the market to move back to the breakout point.
The breakout traders then must watch as the profit they were in on their breakout trades steadily decreases as the market gets closer and closer to the breakout point where they had their trades executed.
Having their profit get smaller and smaller makes the breakout traders scared of potentially coming out of the trade with no profit at all, causing the majority of them to close their trades while there is still a small amount of profit left. Different traders will decide to close their trades at different times, the closer the market gets to the breakout point the higher the number of breakout traders who will be closing their trades.
When the breakout traders close their trades orders will be put into the market which the bank traders will use to get more buy/sell positions placed in the market.
The line on the chart above denominates the point where breakout traders will have had pending orders to buy placed in anticipation of the market breaking out. You can see how the market continues to advance higher after the breakout has took place, the banks begin their profit taking an hour after the breakout occurs and the market begins to fall back to the breakout point causing a retest.
An additional thing to pick up on is the reactive traders who would have placed buy trades onto the candle which caused the breakout. These traders will also add a significant number of buy orders into the market which the banks will use to fill more orders when their profit taking grinds the market lower.
Marking The Zones
Most traders when looking to trade a retest will mark the point where a breakout has occurred using horizontal lines, a far better way of marking the points is using zones, similar to how we do with supply and demand zones.
By marking the breakout point as a zone instead of a line, we give ourselves the benefit of not having to guess which breakout point the traders used to enter their trades. If we were marking the level using a line then we wouldn’t be able to discern which highs or lows the market is going to return to, by having a zone we can cover multiple highs/lows and include them in our total risk when trading the retest.
Using the example we have just talked about we can see there are two highs which breakout traders could have used to enter long trades, we wouldn’t know which one of these highs the market is going to retest, so marking the highs with lines means we may have to take two trades. If we instead mark an area encompassing both highs then we are able to remove some discretion from our decision-making process and also give ourselves a point where we know the trade is likely to be wrong.
Here are the two highs breakout trades could have used as points to enter breakout trades marked with a zone as opposed to a line.
You can see the zone covers the range of both highs, we now don’t need to worry about trying to predict which high the market may return to as we have both included in the size of the zone, we are also able figure out how much to risk on a trade by determining the size of the zone.
In this case the size of the zone is 10 pips, which means when the market returns to the zone and we are watching the lower time-frames for entries long the maximum amount we have to risk is 10 pips, if you were using horizontal lines there wouldn’t be any way for to work out the maximum you need to risk on the trade as it would be impossible to judge how deep the market is going to drop into highs before moving back in the direction of the break.
How To Draw The Breakout Zones
The zones you draw must encompass all of the highs or lows the breakout traders have potentially gone long or short from.
In the example above we have two lows the breakout traders could have used to enter short trades, we need to make sure our zones cover the lows of both lows as this would have been the point where the breakout traders had their pending orders to sell placed.
Since this is a bearish setup the top of the zone needs to be drawn from the candle which created the highest low breakout traders could have possibly gone short from, if the candle which created the highest low is bullish then the zone needs to be drawn from the OPEN of the candle, if the candle creating the low was bearish the zone needs to be drawn from the CLOSE.
Once you have done this you drag the zone down to the lowest low where breakout traders could have entered short trades.
In a bullish scenario the breakout zone needs to be drawn from the candle which created the lowest high, in the example above we only have one high where breakout traders would have placed long trades therefore we only have to draw the zone from one price point as a opposed to two in the previous example. If the candle which formed the lowest high is bearish the zone needs to be drawn from the OPEN. If its bullish it needs to be drawn from the CLOSE.
Entry Into The Retest
How you enter into trades at retests of breakout level is by using candlestick patterns such as engulfing candles or pin bars.
Here we have the zone which I’ve just shown you how to draw but on a 5 minute chart instead of a 1 hour chart.
When you see the market break the lows (or highs for a bullish setup) you need to watch as the market enters into the zone on a lower time-frame to see if there are any candlestick patterns you can use as an entry into the trade.
In the chart above we can see when the market hit the area a bearish engulfing candle formed, upon seeing this you would have entered into a short trade with your stop above the high of the breakout zone. You could decide to put your stop above the high of the engulf but you’ll tend to find you will unnecessarily lose money, because if the market breaks the high of the engulf and you take a loss and then the market moves deeper into the zone before reversing again, then you have basically taken a loss which could have been avoided had you just put your stop at the high if the zone in the first place.
Don’t Use Pending Orders !
Like when trading supply and demand zones, taking trades based on retests of breakout points should not be completed with pending orders.
You wont know if the zone is going to hold or not before the market reaches it, therefore if you place a pending order at an area and the market blasts straight through it you will have lost money which you could have saved had you used a candlestick pattern to enter the trade.
There do happen to be some other rules you must take into account when trading retest at breakout levels.
One of the rules is the level can only be touched once.
What I mean by this is if you have a zone marked on your charts and you see the market return to the breakout zone and proceed to move back in the direction of the breakout you must not use the breakout zone to place any more trades if the market returns. One of the primary concepts of order-flow analysis is the idea that when a technical level has been hit once its significance in the market decrease dramatically and the chances of the market reacting to the level in the same way again is low.
Whilst this rule depends to some extent on the technical level being used, in breakout retest scenarios the idea holds true as if the market to return to the breakout zone again after already being touched the breakout traders who went either long or short on the breakout will not be in their trades anymore, therefore its unlikely the bank trader will be able to place any trades due to there being a lack of orders present in the market.
We can see the area I’ve drawn in orange turns the market on the first touch, but on the second touch the market breaks the area easily and returns to a different technical level.
Another rule is the time it take for the market to return to the breakout point.
This rule is kind of similar to the rule I use in my supply and demand trading where if the market fails to return to a supply or demand zone within 24 hours of its creation the zone is no longer significant and its likely for the market to break the zone upon its return.
The reason I use the same rule when trading breakouts is due to the way breakout traders will not leave their trades open overnight.
Breakout traders will not sit and watch as the profit on their trades gets smaller and smaller, they will always close their trades whilst they still have a little bit of profit left.
The breakout zone above has not had the market return to it for a significant length of time, its unlikely for the market to reverse when it comes back to this level due to the breakout trader not being in their short positions anymore.
My rule for trading breakout zones is the same for trading supply and demand zones…….
“If the market has not returned to the zone within 24 hours do not trade the zone”
This rule is only valid for breakout zones found on the 1 hour chart, if you decide to trade breakout zones on the daily chart then the rule is the market must return to the breakout zone before the end of the month for it to be considered as a valid trading opportunity.
Today’s article was a great example of how you can take an existing strategy and improve it by incorporating concepts from other trading strategies. (in this case the zones from supply and demand trading) Not only does marking breakout level as zones instead of lines make it trading retests easier, it also makes it more profitable.
Now you can quickly define how much you will have to risk on the trade as well knowing when the probability of the trade itself has decreased significantly, if you would like any help or further explanation of how to trade retests at breakout levels please say notify me in the comment section below.