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3 Forex Indicators to Help You Confirm a Breakout

   

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Forex traders bring all kinds of strategies and trading timelines to the table when they analyze forex charts. Both chart patterns and forex indicators can be used to evaluate trade opportunities depending on both your personal trading preferences and the price activity taking place on the forex charts.

When it comes to identifying a price breakout, though, technical indicators can help you determine not only the start of a breakout event, but also the kind of momentum it might carry for traders who open a position at the start of this movement.

Before we discuss the top technical indicators for confirming forex breakouts, though, let’s make sure we understand how breakouts start.

The Basics of a Breakout

Lines of resistance and support provide a reliable framework for understanding price movements and analyzing potential trading opportunities. In forex trading, currency pairs typically see price movements that stay within a fixed range, with price extensions and retracements often corresponding to well-known Fibonacci levels.

When the price moves beyond that line of resistance, it represents a breakout—and many traders will be eager to capitalize on this price action. A breakout is a departure from range-bound price movements and can be caused by a number of factors. What’s important to traders, though, is identifying these breakouts when they occur and realizing the difference between a false alarm and a true breakout that offers profit potential.

To make sense of these price movements and identify lucrative trading opportunities, most traders turn to forex indicators that can help them evaluate the likely strength of a breakout, which, in turn, represents a greater reward for the risk traders take on when opening a position. Here are three widely used forex indicators that can help you confirm a price breakout.

Moving Average Convergence/Divergence

Moving average convergence/divergence (MACD) is a popular tool for evaluating price changes that take place quickly, which helps traders understand the momentum behind a breakout. Through the use of a histogram, traders can see the speed of price changes as price movements approach a line of resistance and break above. With MACD, studious traders can even spot likely breakouts before the price touches the line of resistance based on the rate of the acceleration for the currency pair.

In addition to helping spot a price breakout, MACD can also help traders figure out when to close their position based on slowing momentum, which may indicate an oncoming price reversal. As the histogram used to track momentum starts to plateau or even indicates a reversal, traders should consider placing a stop-loss order or closing out their position altogether to maximize their earnings through this swing in momentum.

In the NZD/USD chart below, a steep price decline in mid-to-late March is followed by a MACD line movement above the signal line, signaling a buy opportunity. This move coincides with a break above the zero line, adding even more strength to this indicator’s buy recommendation:

 

Pros of MACD

The multiple data points incorporated into MACD makes it a more expansive technical indicator than some alternatives. You can also customize this indicator to calculate MACD on shorter timelines if you’re trading in shorter time frames, such as day trading. This can improve the value of MACD in cases where the default calculations are too broad to be consistently relevant.

Cons of MACD

Bear in mind that highly volatile conditions may diminish accuracy because momentum can swing abruptly and wildly. More reliable evaluations of momentum will be achieved when you use this indicator in relatively stable market conditions.


Bollinger Bands

Bollinger Bands are composed of three lines: the 20-day simple moving average (SMA) and parallel lines that represent two standard deviations in either direction from the SMA. Traders use these outer bands to identify price extremes that are likely to lead to a reversal breakout. When the price moves outside of either of these outer bands, it is regarded as an extreme price position that is likely to trigger a reversal breakout.

Traders can use Bollinger Bands by simply opening a position on a currency pair whenever the price crosses one of these bands. To gauge the possible momentum for this breakout, you might consider using MACD or the relative strength index (RSI) in conjunction with Bollinger Bands.

Look at the NZD/USD chart below. Near the same time frame where we saw the MACD line cross the signal line, the currency pair’s price breaks out of the lower Bollinger Band, signaling a buy opportunity before quickly moving back within the bands:

 

Pros of Bollinger Bands

This simple indicator is accessible to beginning traders while still offering value to advanced traders. The bands offer an easy visual representation of currency pair prices that move into overbought or oversold conditions. When looking for breakout opportunities, this can be one of your first indicators to use.

Cons of Bollinger Bands

The simplicity of this indicator also means it’s prone to errors, often due to a failure to account for other important data points. For that reason, traders should think of Bollinger Bands as a starting point for identifying trades, rather than a strong indicator on their own.

This indicator’s approach to identifying overbought and oversold conditions is also similar to the insights offered by other indicators, such as the Relative Strength Index.


Relative Strength Index 

The RSI is a simple technical indicator that is nonetheless relevant when you’re evaluating a potential forex breakout. The RSI uses a 100-point scale to analyze purchasing trends and determine whether conditions for a currency pair are overbought or oversold.

When overbought or oversold conditions develop, it offers a strong indication that a price reversal is about to take place, which can alert traders to potential reversal breakouts resulting from a market correction. When the RSI dips below 30, for example, a forex pair is generally considered to be oversold, and it can signal an oncoming surge in demand for that forex pair—which can lead to a price breakout.

Similarly, if the RSI for a pair is above 70, conditions are considered overbought, and a price decline is likely. The closer the RSI is to either extreme, the more likely it is that you will see a market correction.

In the chart below, notice how NZD/USD drops markedly into oversold territory, and stays there for several days in mid-to-late March. This period of overbought conditions precedes a significant breakout for the pair:

Pros of RSI

As a momentum indicator, RSI is both straightforward and naturally complementary to MACD, which makes them a great pair of indicators to use together. RSI’s track record of identifying overbought and oversold conditions has also been proven not only in forex, but in other markets as well.

Cons of RSI

Because the data used to calculate RSI can lag in a trending market, some instances of RSI will provide a false indication of overbought or oversold conditions. This is more likely on short time frames, such as day and intraday trading, when a brief spike or plunge in price can create an unreliable RSI calculation.

In the NZD/USD chart below, notice how all three of these indicators offer up a buy recommendation around the same time frame in late March. While on their own, these indicators bring their own limitations to this analysis, the fact that all three agree with one another around the same time frame results in a strong buy recommendation—which is rewarded in the days and months to come:

If you’re new to using indicators to spot price breakouts, take your time and experiment with different combinations to figure out which approach makes sense for your situation. No indicator is foolproof, but the combination of analysis tools and an educated eye for forex trading will put you in position to capitalize on these breakout opportunities.

 

The closer the RSI is to either extreme, the more likely it is that you will see a market correction.

If you’re new to using indicators to spot price breakouts, take your time and experiment with different combinations to figure out which approach makes sense for your situation. No indicator is foolproof, but the combination of analysis tools and an educated eye for forex trading will put you in position to capitalize on these breakout opportunities.

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Disclaimer:

The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.

This post was written by Graeme Watkins

CEO Valutrades Limited, Graeme Watkins is an FX and CFD market veteran with more than 10 years experience. Key roles include management, senior systems and controls, sales, project management and operations. Graeme has help significant roles for both brokerages and technology platforms.

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