How Can You Use a Break and Retest Strategy in Trading?

Trading strategies help traders navigate the financial markets with greater confidence. One such approach is the break and retest strategy, which focuses on key support and resistance levels. This article explores the break and retest strategy in detail, providing insights and practical examples to help traders apply it in their trading activities.

Understanding the Break and Retest Strategy

The break and retest strategy is popular among traders who aim to capitalise on clear market movements. At its core, this strategy revolves around identifying key support and resistance levels on a price chart.

Heres how it works: When the price breaks through a support or resistance level, it signals a potential shift in market sentiment. For example, if a stock breaks above a resistance level, it suggests increasing buying interest. Traders then watch for the price to return to this newly broken levelknown as a retest in trading. During the retest, the former resistance now acts as support, providing a potentially more attractive entry point for traders looking to join the trend.

This strategy aligns well with trending markets, where prices move consistently in one direction. It allows traders to take advantage of momentum while managing their entries potentially more effectively.

The Mechanics of Break and Retest Trading

Implementing the break and retest strategy involves a clear sequence of steps that traders follow to identify and act on potential market moves. Heres a breakdown of how this strategy typically operates:

1. Identifying Key Levels

Traders begin by pinpointing significant support and resistance levels on their charts. Accurate identification is crucial, as these levels form the foundation of the strategy.

2. Monitoring for a Breakout

Once the key levels are established, traders watch for the price to break through one of these barriers, in line with a broader trend. A breakout occurs when the price moves decisively above resistance or below support, often accompanied by increased trading volume. This surge in volume indicates stronger market interest and can validate the breakouts legitimacy.

3. Waiting for the Retest

After the breakout, the price typically retraces to test the broken level. For instance, if the price breaks above a resistance level, it may pull back to that same level, which now acts as support. This retest phase is critical as it offers a second confirmation of the breakouts strength.

4. Confirming the Retest

During the retest, traders look for confirmation signals to ensure the breakout is genuine. These signals can include specific candlestick patterns, such as pin bars or engulfing candles, and continued high trading volume. Successful confirmation suggests that the new support or resistance level will hold, increasing the likelihood of a sustained trend.

5. Entering the Trade

With confirmation in place, traders often enter the market, aiming to ride the new trend. They may set stop-loss orders slightly below the new support (in the case of a breakout to the upside) or the new resistance (in case of a breakout to the downside) to manage potential risks.

6. Managing the Trade

Effective trade management involves setting target levels based on previous price action and adjusting stop-loss orders as the trade progresses. This helps to lock in potential returns and potentially protect against unexpected market reversals.

Break and Retest Example Strategy

Consider this EURUSD 15-minute chart, which displays a clear bearish trend. This trend is highlighted by the 50-period Exponential Moving Average (EMA) sloping downward, with the price generally staying below it. Recently, the price broke below a key support level on higher-than-average volume, signalling a potential opportunity for traders to apply the break and retest strategy.

In this scenario, there are two support levels to monitor. The first is a more significant support level. Trading at this level can allow traders to enter the market quickly, though it comes with a less favourable risk-reward ratio.

The second support level is found within the recent brief retracement. This level offers a better risk-reward ratio, but there's a chance the price may not retrace deeply enough, potentially causing traders to miss the trade.

The entry point is identified by a candle with a wick longer than its body (a pin-bar on the 30m chart), indicating rejection of higher prices as the market retests the second broken support level. Once this candle closes, traders can enter a market order.

Stop losses would typically be placed either above the last major swing high or above the 50-period EMA, depending on individual risk tolerance. Take-profit targets could be set at a 1:3 risk-reward ratio or at the next significant support level, where a price reversal may be anticipated.

Improving the Break and Retest Strategy

Enhancing the break and retest strategy involves integrating additional tools and techniques to refine trade decisions. Here are several methods to consider:

1. Incorporating Additional Indicators

Using break and retest indicators like the Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD) can provide valuable insights. For instance, an RSI crossing below 70 during a bearish breakout may indicate weakening momentum, supporting the retest. Similarly, the MACD crossing above its signal line or the MACD histogram rising above 0 can confirm the uptrends strength, aiding in more precise entry points.

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2. Multi-Timeframe Analysis

Examining charts across different timeframes helps in gaining a broader market perspective. A breakout observed on a 4-hour chart gains additional confirmation when a strong trend is also visible on a daily chart. This alignment across timeframes increases the reliability of the trade setup.

3. Utilising Fibonacci Retracements

After a breakout, prices often retrace deeper into the previous high-low rangenot always to the most extreme point. Applying Fibonacci retracements to the high/low of the breakout (high in a bearish breakout and low in a bullish scenario) and the new low or high can help identify optimal retest points, particularly at the 38.2%, 50%, and 61.8% levels. These levels typically offer better risk-reward ratios compared to the extreme points.

4. Incorporating Fundamental Analysis

Supporting technical breakouts with fundamental factors, such as economic reports or news events, strengthens the strategy. For example, a breakout aligned with positive economic data may have a higher probability of sustaining the new trend, providing traders with greater confidence in their decisions.

Advantages of the Break and Retest Strategy

The break and retest strategy offers several advantages that can enhance a traders approach to the markets:

Increased Confidence through Confirmation: The retest serves as an additional validation of the breakout, boosting trader confidence in their entry decision and reducing hesitation.
Better Risk Management: Setting stop-loss orders based on the retest level provides a clear risk boundary. This structured approach aids in potentially managing losses.
Alignment with Market Trends: This strategy naturally aligns trades with the prevailing market trend. By trading in the direction of the breakout, traders can take advantage of sustained movements.
Versatility Across Markets: The breakout and retest strategy can be applied to various financial instruments, including forex, stocks, and commodities. Its adaptability makes it a valuable tool in diverse trading environments.
Scalability and Flexibility: This strategy can be adapted to different timeframes and trading styles, making it suitable for both short-term and long-term traders seeking to implement a consistent approach.

Potential Challenges and Considerations

While the break and retest strategy can be a powerful tool, traders may face several challenges when implementing it:

False Breakouts: Not every breakout leads to a sustained trend. Sometimes, the price moves beyond a support or resistance level only to reverse shortly after. Recognising these false signals is crucial to avoid entering trades that may quickly turn against expectations.
Market Conditions: According to theory, this strategy performs best in trending markets. In sideways or highly volatile environments, breakouts can be less reliable, making it harder to distinguish genuine opportunities from random price movements.
Timing the Retest: Accurately determining when the price will retest the broken level can be challenging. Entering too early may expose traders to unnecessary risk, while waiting too long might result in missed opportunities if the retest doesn't occur as anticipated.
Reliance on Confirmation Signals: While additional indicators like RSI or MACD can enhance the strategy, over-reliance on these tools can complicate decision-making. Traders need to balance multiple signals without becoming overwhelmed or confused.
Emotional Discipline: Maintaining discipline during retests is essential. Traders might feel pressured to act quickly if the market moves unexpectedly, leading to impulsive decisions that deviate from their trading plan.

The Bottom Line

The break and retest strategy offers a structured approach to navigating market movements, combining precise entry points with effective risk management. By understanding and applying this method, traders can potentially enhance their trading decisions and align with prevailing trends. To put this strategy into practice across more than 700 markets, consider opening an FXOpen account and gain access to four advanced trading platforms, low trading costs, and rapid execution speeds.

FAQ

What Is a Retest in Trading?

A retest occurs when the price returns to a broken support or resistance level after an initial breakout. It serves to confirm the strength of the breakout, helping traders decide whether the new trend will continue or if the breakout was false.

What Is the Break and Retest Strategy?

The break and retest strategy involves identifying a breakout of a key support or resistance level and then waiting for the price to return to that level. Traders use this retest as a confirmation to enter the market, aiming to follow the new trend with reduced risk.

What Is the Win Rate of the Break and Retest Strategy?

The win rate of the break and retest strategy varies depending on market conditions and how the strategy is applied. Consistent application and effective risk management are crucial for achieving better results.

How Many Times Should I Backtest My Strategy?

Backtesting should be done extensively across different market conditions and timeframes. According to theory, traders need to test a strategy on at least 100 trades to ensure its reliability and to understand how it performs in various scenarios.

Does the Market Always Retest?

No, the market does not always retest broken levels. While retests are common, they are not guaranteed. Traders should use additional confirmation signals and be prepared for both possibilities when applying the break and retest strategy.

Text source: Forex Trading Blog

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