who are lured to it by the prospect of attaining easy big profits in little time. Who
doesn’t like to get a reserved seat at the turnaround of a trend as the ride gets
propelled by a frenzied momentum? However, things are certainly not as simple as
they may seem on the surface.
First of all, how do you know if a breakout is going to reverse the current trend?
To get some clues as to whether a trend could be reversing, you should scrutinise
the currency price charts, and look out for certain reversal chart patterns that tend
to serve as harbingers of a trend change. Examples of such patterns include the
head-and-shoulders, double top/bottom, triple top/bottom and so on. If you do spot
these formations in your charts especially in the daily or weekly chart, there is a
high chance that a reversal may be in the works, and that you should get ready for
trading a breakout.
In addition to these chart patterns, you can also make use of momentum indicators
to tell you if a trend is nearing its end.
Using momentum indicators
Momentum indicators, also known as oscillators, often lead price actions, and they
help to alert traders to turning points such as a trend reversal breakout.
Moving Average Convergence/Divergence (MACD)
MACD is one of the simplest yet most dependable indicators available in the
toolbox of a trader. MACD consists of three exponential moving averages, even
though only two lines appear on the chart. The MACD line itself is the difference
between a currency pair’s 12-period and 26-period exponential moving averages
(EMA). Usually, a signal line made up of a 9-period EMA of the MACD line is
plotted together with MACD. A bullish signal is given when the MACD line
crosses above its signal line, and a bearish signal occurs when the MACD line
crosses below its signal line.
A better visual representation of MACD was invented by Thomas Aspray in the
form of a MACD histogram, which is made up of a series of vertical lines. The
histogram simply represents the difference between the MACD line and its signal
line, and is plotted around the zero line. The histogram is positive (above zero line)
when the MACD line is above its signal line, and is negative (below zero line)
when the MACD line is below its signal line.
The MACD histogram tracks the speed of the price movement, and reflects the
speed by the way it slopes. For example, if a price move accelerates with an upside
breakout to a level higher as buyers are in a frenzy to buy the currency, then other
buyers will be eager to join in as they anticipate a continuation of the rally at the
same time that many people who have shorted are being stopped out, pushing the
rally higher. Under such circumstances, the histogram should become bigger (each
line becoming longer than the previous line) as the speed of the price movement
accelerates in a quick rally. On the other hand, when the price movement
decelerates, the histogram should contract (each line becoming shorter than the
previous line) accordingly. The reverse is true for a downside breakout.
MACD divergence signals
If you want to detect a trend reversal breakout, there is a way you can exploit this
momentum feature of MACD, and that is through MACD divergence signals.
When a currency pair rallies to a new high, or moves sideways, but the MACD
histogram declines, then a bearish divergence is formed. The bearish
divergence in MACD mostly takes place above the zero line because prior upward
price movement would have resulted in MACD moving into positive territory. A
bullish divergence in MACD results when a currency pair declines to a new low or
moves sideways, but theMACD histogram slopes up higher instead of sloping lower.
Hence, when you spot a potential breakout scenario on a currency price chart, you
should also take note of how the MACD histogram is performing. If the currency
has been making new highs, has the MACD histogram been doing the same by
forming higher peaks? If so, you can assume that the uptrend is still in place, and
perhaps any breakout to the downside would be short-lived or probably false.
However, if the MACD histogram shows a bearish divergence, then you will have
a strong signal that a downside breakout is more likely to be sustained than false.
The reverse applies to a bullish divergence. Although an MACD divergence signal
seldom occurs, it is generally a very strong reliable signal when it does make an
appearance.
Relative Strength Index (RSI)
Another momentum indicator that can help you anticipate rather than react to price
changes especially when prices are at the verge of breaking out is the RSI. The RSI
measures the relative changes between higher and lower closing prices over a given
time period, and provides an indication of overbought and oversold conditions.
This is the formula for RSI:
RSI = 100 - 100 / (1 + RS)
where
RS = (total gains / n) / (total losses / n)
n = number of RSI periods
Areading of 30 or below indicates that the currency pair is in an oversold condition,
and a reading of 70 or above indicates that the currency pair is in an overbought
condition. However, it is not so useful to use this overbought/oversold condition for
gauging the outlook of a potential breakout on the currency price chart as
momentum indicators do not work as well during trending phases. An uptrend
could register a prolonged period of overbought conditions, whereas a downtrend
could register a prolonged period of oversold conditions (See Figure 8.6).
RSI divergence signals
The most useful way of applying the RSI is through its divergence signals. When
divergence starts to appear after a directional move, it strongly indicates that a turning
point of the current trend is near, and can help you gauge reversal price breakouts. Like
MACD, bullish divergence occurs when a currency pair declines to a new low, but the
RSI makes a higher low. Bearish divergence is simply the opposite – a currency pair
rallies to a new high, but RSI makes a lower high instead.
How does this price-RSI divergence occur?
As you can tell from the RSI’s calculation, the average up closes for a period is
divided by the average down closes over the same period. This is how a bearish
divergence may take place: In an uptrend, a currency pair will advance to higher
highs, and result in more average up closes compared to the down closes. Both the
price and the RSI will then reach a peak reflecting this. Usually, after an advance,
the currency pair tends to take a break and consolidate for a while before deciding
the next move. Currency prices may retrace slightly or move sideways during this
time. This decline or sideway move in prices will cause the RSI to slope downward
from its peak since the number of times the currency pair is up in price divided by
the number of times the currency pair is down in price decreases.
When the currency pair later tests or moves slightly higher than its previous high,
the RSI will form a lower peak this time compared to its previous peak, since the
RSI formula takes into consideration the period of decline and consolidation. This
lower peak may signal that the bulls are not as strong as they seem to be, and they
could be running out of buying power if no new bulls enter the market. This bearish
divergence warns of a potential trend reversal ahead, and if the currency pair is
close to touching a support level, a breakout to the downside is more likely to be
sustained and successful than short-lived and false. The opposite situation is true
for a bullish divergence.
For the Breakout Trading Strategy, using momentum indicators like MACD or the
RSI can sometimes provide clues to internal trend weakness since momentum
precedes price change. While it may be impossible to predict with 100% accuracy
the success of a breakout, as well as the length and duration of the subsequent
breakout move, you can make use of these momentum tools to alert you to the
possibility of a significant reaction or even a trend reversal breakout of the
currency pair.
Source: 7 Winning Strategies for Trading Forex: Real and Actionable Techniques for Profiting from the Currency Markets
