Filtering False Breakouts

By: Kathy Lein

The following is an excerpt taken from Kathy Lein’s Day Trading the Currency Market

Trading breakouts can be a very rewarding but frustrating endeavor as many breakouts have a tendency to fail.  A major reason why this occurs frequently in the foreign exchange market is because the market is much more technically driven than many of the other markets and as a result there are many market participants who intentionally look to break pairs out in order to suck in other nonsuspecting traders.  In an effort to filter out potential false breakouts, a price action screener should be used to identify those breakouts that have a higher probability of success.  The rules behind this strategy are specifically developed to take advantage of strong trending markets that make new highs that then proceed to fail by taking out a recent low and then reverse again to make other new highs.  This type of setup tends to have a very high success rate as it allows traders to enter strongly trending markets after weaker players have been flushed out, only to have real money players reenter the market and push the pair up to make major highs.

Strategy Rules:

LONG:

1. Look for a currency pair that is making a 20-day high.
2. Look for the pair to reverse over the next three days to make a two-day low.
3. Buy the pair if it takes out the 20-day high within three days of making the two-day low.
4. Place the initial stop a few pips below the original two-day low that was identified in step 2.
5. Protect any profits with a trailing stop or take profit by double the amount risked.

SHORT:

1. Look for a currency pair that is making a 20-day low.
2. Look for the pair to reverse over the next three days to make a two-day high.
3. Sell the pair if it trades below the 20-day low within three days of making the two-day high.
4. Risk up to a few ticks above the original two-day high that was identified in step 2.
5. Protect profits with a trailing stop or take profit by double the amount risked.