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How To Trade Pullbacks

Updated: Nov 19, 2022

Trading Pullbacks as a swing trading strategy


One of the most common entry techniques used by swing traders is the buying of breakouts from consolidations or bases, which is the approach I take.

The next best technique is entering the pullback itself.


However, initiating a trade in a pullback is a skill that a trader develops over time. You can’t buy or sell any pullback and need to be cognizant of traits to look for while trading the pullbacks.


I created a swing trading video for those looking to learn more on the subject:


How To Trade Pullbacks


Benefits of entering in pullbacks


· Pullbacks usually lower your cost base.

· Often easier to buy the stock when the price is resting than when it’s breaking out to new highs and moving quickly.


Reversal vs Pullback


Picking up a short lesson from the Dow Theory, which states that the price has three trends:


1) Primary trend which is the long-term trend,

2) Secondary trend, which is a pullback within the primary trend and

3) Minor trends lasting for short periods, which is often simply noise.


Then there are phases in the primary trend called, accumulation, public participation, excess in an uptrend, distribution, public participation, and panic in a downtrend. Clicking on the video below will help you better understand this concept.



The most important part of trading pullbacks is to differentiate between a potential reversal (start of a downtrend) and a pullback (secondary trend), as they both look the same in the beginning.


An entry into a reversal can be quite damaging because reversals are quick, sharp, and often painful, sometimes bringing in severe account drawdowns. Pullbacks, on the other hand, are quite different than reversals and have to be skilfully analysed to not confuse reversals with pullbacks. There are traits you can look for to differentiate between the two.


A reversal of the primary trend generally happens when the price has been trending for a good time – ranging from a few months to several years, until there is a change, often in fundamentals.


For example, below is the chart of Zoom Inc., which saw a mammoth rise during the COVID period and subsequently reversed all the price performance as the pandemic subsided (fundamental change).

In the uptrend, the stock gave a few buyable pullbacks, before it peaked and reversed on high volumes. The sharp reversal erased all the price performance of the uptrend.



Here are few major differences between a reversal and a pullback:


· A pullback is generally a low volume consolidation, while a reversal is a higher volume decline


· Reversals generally happen when the trend has aged while pullbacks occur at all times within the trend. The earlier ones often have the best odds of working.


· Reversals occur when the story is quite public and fundamentals have peaked, while tradable pullbacks happen when the story is developing and the investor community is still researching the story


· Pullbacks respect major moving averages like 50-day and 200-day, and trendlines, while reversals cut through them violently and fail to reclaim them.


How to trade a pullback


Trading a pullback isn’t as simple as buying a falling stock or shorting a rising stock. As stated earlier, there are several nuances for entering in pullbacks. Some of them help you screen for tradable pullbacks, while others help you execute the trade at low-risk entry points.


Let's start with the screening criteria first:


· Select pullbacks that aren’t too far in the price move. Pullbacks that occur at the start or mid of the trend have higher chances of success. Stocks that enter the distribution phase are risky to trade in pullbacks


· Look for stocks respecting their major short-term moving averages, especially 21-day and 50-day moving averages


· Look for pullbacks that aren’t too aged. 2-8 weeks is a sweet spot for good pullback trades.


· Keep an eye on support and resistance levels. Stocks respecting support and resistance levels are good candidates to enter in pullbacks


· Look for stocks respecting their trendlines


Apart from the screening parameters mentioned above, there are some rules that you would need to follow to profitably trade pullbacks.


Entries in swing trading should always be based on the technical set-up. Most importantly, you must enter when the risk on the trade is the lowest so that you know quite quickly when you are wrong.




Most pullbacks have a structure. On the chart, the price may form red bars for a few days and weeks making new intermediate lows followed by a reversal bar towards the bottom. For example, in the weekly NASDAQ 100 chart below, the index pulled back for three weeks and made a reversal bar in the fourth week.


A good pullback trade would have been to buy at the close of the reversal week, with a stop loss at the low of the week, which was 5% away from the close. This would have given a low-risk entry.


If you are trading individual stocks, look for tight entries in the reversal week. To keep your risk even lower, you could trade low volatile stocks. Alternatively, you can reduce your position size and trade high volatile stocks with wider stop losses.


You can also trade reversals using moving averages and trendlines. In the weekly chart below, Tesla respected and bounced off the 10-week moving average (50-day) on three occasions in the pullback.



A good pullback trade could have been buying at the reclamation of the moving average, with a stop loss 2-3% below the moving average or at the low of the weekly bar.


Trending prices respect trendlines and moving averages with surprising consistency, making these areas some of the best points to enter a pullback.

Although remember nothing is certain, we can only increase our probability of success and a pullback could offer rationale to do just that.


Conclusion


Entering pullbacks is one of the major pain points for newbies in trading. That’s because they hit the buy button as soon as they see a deep cut. In fact, most new traders enter reversals and become compulsive investors, waiting to break even. Such break-evens never happen.


When you have enough experience trading, you can look at the technical and fundamental set-up to differentiate between a reversal and a pullback. The ideal here is to focus on stocks where the momentum has recently begun, rather than stocks that have seen several weeks and months of large returns already.


It always comes down to developing an eye for such setups. The good news is that it comes easily with practice. Trade light, keep your losses small, make incremental progress, and persevere.


My trading approach is through consolidation breakouts where my PDF link can be seen below. I do however use a pullback approach on the major indices where their diversification always allow for an eventual trend to all time highs (Unlike singular stocks). The video below showing that approach may be of use.


My breakout strategy - 15 page rule book (PDF) is available for all members to use.

My Breakout Scanner - https://bit.ly/3ea6sl8

My Brokerage Account (Interactive Brokers) - https://bit.ly/3HVA1nc




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1 Comment


This is pretty solid advice as always. Thanks. One strategy to consider is to examine the chart of a strongly trending stock and putting in a limit order at the exact point at which you want to buy. Usually close to support / resistance. This enables a tight stop loss, just outside support/resistance, and swings the risk/reward ratio in your favour. This strategy will mean missing out on 50-75% good opportunities, but in return there should be fewer big losses.

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