Justin is an active trader with more than 20-years of industry experience. He has worked at big banks and hedge funds including Citigroup, D. E. Shaw and Millennium Capital Management.
Pullback trading strategies are popular because they are relatively simple to identify and have a solid track record in terms of investor returns. The process involves getting an understanding of market conditions and what a pullback is, and then, once a trend has been identified, establishing which indicators are best for identifying trade entry and exit points.
Pullback strategies are based on the idea that following the herd is a good thing. It quite often is, but this article will establish ways that returns can be optimised and what other factors traders need to look out for.
In this article, we’ll use real-life trade examples to look through:
Market pullbacks are probably best explained through the use of a chart. The below 15-year chart for the S&P 500 outlines how price in the world’s flagship equity index has thrown up a whole number of trading opportunities. The index includes the world’s largest 500 firms by market capitalisation, and points A, B and C on the chart denote short-term pullbacks that created trading opportunities.
Pullback trading works on the basis that price doesn’t move in a straight line, and while the long-term trend is for prices to rise, the moments when uncertainty grips, the markets offer opportunities to buy into a market at a lower level.
Pullback strategies can work over any time-frame and in any market. The below intraday candlestick chart shows the same instrument, the S&P 500 index, with timeframes set to five-minute intervals. The principles are the same, with pullback buying opportunities once more identified.
Pullback trading has long been associated with bullish equity markets. The multi-year upward trend in the ever-popular stock markets has encouraged a lot of equity investors to focus on efforts to ‘buy the dips’. While pullbacks have become associated with upward trends, the principles can be applied to markets with downward momentum.
In the below example, the price of gold fell from $2,034 in August 2020 to $1,697 in March 2021. The tramlines highlight a textbook-quality downward trend, with the pullbacks marked A and B being opportunities to sell, or sell short, the asset.
One term that it pays to get to grips with is ‘retracement’ – a term used interchangeably with pullback. In the below example, a trader who is active in the gold market during the same period as above buys at X and sells at Y and is trading the retracement. This strategy relies on there being periods of time when market price goes in the opposite direction to the long-term trend. Some strategies specialise in trading retracement opportunities, but there are additional risks involved with those because they are taking positions against overall market momentum – so if they do go wrong, losses can be magnified.
While the terms are used interchangeably, a pullback is typically viewed as being shorter-lived than a retracement.
A market ‘correction’ is when price reverses by more than 10% from its 52-week high. These can take some time to happen, and in the case of major stock indices are relatively rare.
Reversal is another term that is used in the same context. This term is usually applied to a fundamental shift in market dynamics. It might be that a firm has announced news to the market, which means that many think that it is now overvalued. A pullback, in contrast, is more likely to be used to describe a moment when buying pressure subsides for a short time, but where the underlying situation is unchanged.
Making the decision to trade with market momentum rather than against it is step one, but raises the question of how to spot trends. The trends illustrated in the charts so far are easy enough to understand, but don’t forget that at point A and B in the charts, the future price move was at that time unknown.
One of the fundamental factors to consider is ‘higher highs and higher lows’, which is an adage used to spot upward-trending markets. For downward-trending ones, the things to look out for would be ‘lower lows and lower highs’.
Another tool to use is trend-line chart graphics. The downward channel in the gold market trade example is the kind of thing to look out for. It should be noted that the lines won’t always be as parallel as they are in this case.
The example below shows that Bitcoin’s price surge in the second half of 2020 could have two separate trend lines applied to it. T1 and T2 both have a valid case for being considered, with the general rule being that the more times price touches a trend line, the stronger that line is as an indicator.
T2 starts from an earlier date, but T1 more closely reflects price action, and those who used T1 as their trading signal would have made a large profit on any long position, assuming that they sold when price broke the support line, signalling that the trend was over. Those using T2 as a guide would have sold out at a later date and a lower price as denoted by the arrow.
Trading pullbacks requires a degree of patience. The price movement is one big giveaway that a pullback is occurring – price falling away from a price peak being the obvious signal. There are other metrics to consider and, as importantly, at what time to step into the market to trade. At the time that price starts to change direction, there is every chance that the move could be more than short-lived.
The obvious risk for any pullback strategy is that the price move may be more substantial than expected. A lot of the trade entry ideas relating to the strategy are based around managing that risk.
Once price starts falling back, a lot of the market will consider buying in at certain price levels, which are denoted by other technical analysis indicators. Examples of these are Fibonacci levels and moving averages. The greater number of trading signals that align to identify a trading signal, the more reliable the trading decision.
Traditional investment methodology proposes working into a position in stages. This would involve buying at one support level and if price breaks that level, then buying at the next one. This way, the average price of a position is lower than if trading was carried out in an ‘all-in’ manner.
Stop losses are automated instructions to trade out of all or some of a position if price reaches a certain point. They can be particularly useful for those using ‘higher highs, higher lows’, with the low points being called ‘swing lows’ or trend lines as a trading guide.
In the below example taken from the EURUSD forex pair, buying activity takes place between points B and C. The stop loss on these positions is set just below the previous higher low. If that price level is broken, then the trend will be thought of as ended.
While the underlying principles are as simple as buy it low, sell it high, there are a lot of factors to consider. Part of the skill of running pullback strategies is being able to identify the underlying trend and developing the skills to trade into positions effectively. This can take time, and practicing using a demo account and trading virtual funds is one way to approach the situation.
Pullback strategies can be used in conjunction with a range of other indicators and strategies, including:
The AUDUSD forex pair is often used to trade global appetite for risk. The Australian dollar thrives in times of stability and global economic growth. Its raw material trade with booming Asian economies, particularly China, drives up demand for the Australian currency as importers of iron and copper ore buy the currency to facilitate international trade transactions.
The US dollar, in contrast, is seen as more of a safe-haven asset. When geopolitical risk ratchets up, the security of holding the world’s de facto reserve currency becomes appealing for investors around the world.
In the below chart, AUDUSD has been trading sideways through the quiet summer months. The most recent downward trend, which started near the price level 0.75 printed on 3rd September, could be one worth trading via a short position in the currency pair.
If price is heading to the lower end of the trading range, the target price could be as low as 0.7114.
Zooming in on the one-hour chart, a trend-line channel is confirmed and there is a series of lower highs and lower lows. If current price can manage to trade lower than 0.730, the level of the most recent lower low, then that will be a strong indication that the swing high pattern is confirmed. Short positions could be expected to be placed with individual risk profiles determining at what level stop losses are placed. Contenders include:
Target prices could include:
Additional confirmation that the downward trend might continue is provided by the simple moving averages of the one-hour and one-day price charts all being above current price. Those ever-shifting price levels would provide resistance to any upward move.
The SMA on a Weekly timeframe illustrates that the 100 Weekly SMA provided resistance to the last downward move and so helped form the lower level of the three-month trading range. [Green circle in the below chart.]
The 100 Weekly SMA is rising, but only gradually. Currently at 0.71605, that metric looks to be having a considerable influence on price, so would potentially limit the chances of price breaking through the 0.730 support, or potentially even reaching it if it can be expected that the SMA continues its gradual upward movement.
One of the major benefits of pullback strategies is that those who manage to catch a trend, and resist the temptation to sell too early, can make significant returns. Learning the skills to spot trends and developing the discipline to trade with them, not against them, is one of the first steps towards successful trading. Trend reversal signals such as a break of the swing low pattern also offer clear clues when momentum has turned and exiting a position is likely to be a good option.
The major risk and one that is unavoidable is that what looks like a short-term pullback could be something much more substantial. This means that pullback strategies are most effective when incorporated with other indicators.
Pullback strategies are widely used and are less about having a secret strategy that will beat the market and more about trading in line with the rest of the market, which is always a good idea.
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