When the market price of a stock declines, and when probability suggests that the decline will be short-lived, traders look for buying opportunities. Enter pullback trading. A stock market pullback allows traders to buy a stock when the price is low and sell it for a tidy profit when the overall upward trend resumes. It’s important to distinguish pullbacks from other investment patterns and to understand why pullbacks occur.
Pullbacks can cause a lot of panic and early exits for beginning traders. So what is a pullback? Should you be frightened?
“Pullback” is a technical analysis term used when referring to stock resistance levels. It’s a temporary pause or moderate drop in an asset’s long-term uptrend. Typically, a stock drops 5% to 10% during a pullback. As its upward trend falters at a resistance level, it drops back toward a support level.
Pullbacks are short-term phenomena and occur relatively often. In fact, they happen around 20% of the time. In this article, you’ll learn how to best utilize pullbacks to optimize your gains in the market and accumulate profit.
How do you profit from trading pullbacks?
One of the most important steps in pullback trading is gauging when to enter and exit. To profit, you’ll have to sell the stock when the upward trend reasserts itself in the future.
Pullback trading limitations
The biggest limitation of pullback trading is that any apparent pullback could be the start of a true reversal pattern. If the price breaks below a trend line, you could be dealing with a true reversal rather than a mere pullback.
When a true reversal is just getting started is not the time to enter a bullish position. But how can one tell if a drop in an upward-trending stock’s price is a pullback signaling an opportunity to buy or a reversal leading into a downtrend that will last?
Many traders believe the answer to this question lies in technical analysis. By identifying technical support levels, these traders believe they can distinguish between temporary pullbacks that leave bullish trends in place and genuine reversals that signal a bullish trend turning bearish. Tools traders use to identify support levels include moving averages, previous reaction lows, trend lines, and Fibonacci retracement. Complex technical analysis tools can increase the confidence of traders who believe in the validity of this kind of analysis.
In the forex (foreign exchange) market, people make money by trading in global currencies. The market determines the rate for every global currency relative to others. A particular currency’s price (or exchange rate) could be ascending or descending in terms of another currency. For instance, the price of British pounds in U.S. dollars might drop from, say, $1.50 per 1 £ to, perhaps, $1.25 per 1 £.
Since foreign exchange requires pricing one currency in terms of another, the forex markets deal with currencies in pairs, such as the U.S. dollar / British pound pairing. Because the exchange values of currencies change constantly, forex trading is popular among frequent traders employing technical analysis. In fact, the forex market is the most active global trading marketplace.
Pullbacks occur often in the forex market. Traders use pullbacks to enter market positions at the best possible exchange rates. For example, investors will trade one currency for another when the currency they are trading for pulls back in price relative to the currency they are holding.
Say the British pound is trending up relative to the U.S. dollar. This is not the trend at the time of this writing, but that doesn’t matter for the illustration. In this scenario, the time to buy British £s is when their value pulls back from $1.50 per £ to $1.25 per £. When the pullback ends and the uptrend resumes, you can then sell the £s back for dollars at a profit.
Spotting pullback pivot points in a forex market means looking at trend lines. When an analyst can draw a line between three peaks or highs in a price chart, or between three lows, that line is a trend line. The top line connecting three highs indicates resistance. The bottom line connecting three lows indicates support. Since a pullback is any drop in price after a peak, the area under the top trend line may be called the pullback area.
Traders can use trend lines to help them decide how to profit from pullbacks. There are probably as many specific strategies for trading pullbacks as there are technical analysts, but the wide range of categories can be generally described as comprising two major strategies you can use for this kind of trading: the aggressive and the conservative approach.
For convenience, we will sometimes refer to “stocks” as the things being priced, bought, and sold. Bear in mind that this is only for convenience and that traders apply similar methods to much more than stocks, such as currencies (forex) and commodities.
Aggressive pullback trading approach
An aggressive approach is to enter trades anytime the price pulls back below the upper trend line. The thinking here would be that the next high in the upward trend will be even higher, allowing you to make a nice profit by selling. You might enter a limit order (an order to sell when the stock rises to a certain price or higher) in anticipation of the next high.
All strategies carry risks, and the risk here is that the pullback will not stop before crossing the bottom trend line. When this happens, technical analysts believe, what was a line indicating support becomes a line of resistance for a trend that will be lower overall going forward. Traders usually protect themselves from catastrophic losses by entering stop-loss orders, orders that trigger the sale of shares if they drop to some price or lower. Stop-loss orders mean losing money, but they also mean stopping your losses sooner rather than later.
Conservative pullback trading approach
Pullback trading becomes more conservative the longer you wait to execute a buy order after the pullback begins. The most conservative approach is to wait until you see the first uptick in price signaling that the pullback is over.
You might even place a stop buy order a bit above the current price if you want to wait to see the new upward trend confirmed. If the trend fails before your stop, your buy order won’t execute (a stop buy order only triggers at or above your stop price) and you can keep waiting for the downward trend to end.
How do you identify a pullback?
As you’ve already learned, a pullback is a short-term drop in an asset’s value, usually between 5% and 10%. They’re a common temporary setback in a longer-term trend.
Another way to think about them is in terms of supply and demand. When a stock’s price increases, fewer buyers are willing to pay the higher prices. As demand declines, prices eventually begin to fall to a lower price that attracts more buyers. That’s how the stock market works. That fall to a lower price is a pullback and can be an investment opportunity.
Believers in technical analysis employ various methods to identify and take advantage of pullbacks. Let’s review one of them now.
Candlesticks are the price indicators, typically colored green and red, that you see on some charts showing price changes of stocks, commodities, and anything else you might trade. In theory, a single candlestick can summarize the price action for any time interval, from a mere minute to several days. If an entire day’s data is in view, the close and open price indicated will be the prices at the opening and closing of trading for the day. Otherwise, they will indicate the opening and closing prices over the interval.
Though the “candlestick” name would make you expect to call the extensions beyond the main body “wicks,” few people refer to them that way. You can learn the essentials of candlestick anaylsis by reading our article How To Read Candlestick Charts.
Why traders and other investors value candlesticks
Many active traders believe that candlestick analysis provides accurate and useful insights into the sentiments driving price trends in the market, allowing them to predict future trends in a way that is likely to be correct more often than it is incorrect.
These traders believe that candlestick price bars form recognizable patterns that can be used to predict future price action and momentum. Learning these patterns is fairly straightforward. Successfully identifying them in the market and using them to improve your trading is an art as much as a science and demands both sustained discipline and a lot of practice.
The image above covers several common candlestick patterns. As already noted, you can learn more about these, and about candlestick analysis more generally, by reading our article about how to read candlestick charts. In addition to active traders, who use candlestick and other technical analysis methods to guide their actions, more traditional buy-and-hold investors may inspect candlestick patterns to choose when to buy a stock they consider undervalued.
In the opinion of many, understanding the basics of candlestick charts is essential before moving on to the many more complex, sometimes even abstruse, varieties of technical analysis.
Beware of a dead cat bounce
Traders use the phrase “dead cat bounce” to describe a type of bull trap that you should look out for when trading. You spring this trap on yourself when you buy a stock because you identify a temporary rally in a downward trending stock as a reversal beginning an upward trend. Your bullish buy turns into a loss shortly thereafter when the downward trend resumes.
The gruesome imagery highlights how the fact that a plunging stock bounces up a bit doesn’t prove there’s any real life in the stock. Even a dead cat can bounce. In fact, there is apparently an old saying suggesting a dead cat is more likely to bounce if it falls from a great enough height, but this may not be good physics and could be misleading. When a dead stock bounces, it hasn’t hit the ground. Instead, it’s still on its way down a long flight of stairs.
To learn more about the perils of the dead cat bounce, read our article about the dead cat bounce in stock investing.
Pay attention to trading volume
Regardless of what trading platform you use, you will likely be able to include volume indicators on your price charts. You should take advantage of this.
For instance, if the volume has been low as the stock price has been rising but jumps up to a very high level during the pullback, ask yourself what that might mean. Did some news come out that spooked large investors? Did an insider make a big sale? The reason for the change in volume could tell you how likely it is that this is just a pullback and not a reversal.
Be cautious when using technical analysis
When you first start using the methods of technical analysis, such as working with candlestick patterns, be very careful. For some investors, technical analysis ends up being just a way to feel smarter as they lose money. Here are some points of caution to keep in mind as you learn and apply technical analysis:
- Technical analysis is not an oracle, prophet, or crystal ball. The best it can do is give you a sense of what future price movements are most likely. Always hedge your bets and have contingency plans.
- If you think you’ve discovered something with technical analysis that no one else knows about, think again. If you see something in the chart, take it for granted that many other investors see it, too. How might the actions these many investors take affect the outcome you are trying to predict?
- Be aware that there are much bigger players out there who’ve not only mastered technical analysis but have proprietary methods the public doesn’t know about. Quants, or quantitative analysts, for instance, operate entire firms that apply advanced and proprietary methods of analysis to large numbers of stock that they trade frequently. Often, a prediction about upcoming price moves that has just occurred to you will have become apparent to these bigger players days earlier. How might this affect what the price actually does going forward? How should that effect influence your trading decisions?
Why do stocks pull back?
Pullbacks happen for all sorts of reasons. Prudent investors often take profits (sell some stocks) when an upward trend has been underway for a long time. This ensures that they keep some of their gains even if a pullback or reversal occurs. When large investors do this, that selling pressure can be enough to cause a pullback.
In today’s market, computers can also be responsible for pullbacks. A high volume of trading these days gets done by computers following complex algorithms and crawling the Web for news keywords about the economy as a whole and about specific sectors and specific companies. Even online discussions of stocks and the economy can get factored into buying and selling decisions. After all, these online discussions are a window into investor sentiment, and investor sentiment influences investor actions.
Unexpected bad news about a company can cause a pullback. An earnings report that is bad or, oddly enough, just less good than analysts expected, can cause a pullback. A drop in oil prices can cause a pullback in oil stocks, even in energy stocks more broadly. Public belief that the economy as a whole is entering a crisis or headed in the wrong direction can cause large numbers of stocks to pull back.
In sum, there are many potential causes for pullbacks.
What does a pullback tell you?
No doubt you’ve heard this popular investing advice: “buy the dip.” If the dip is just a pullback and not a reversal, what it tells you is to buy or get ready to buy, depending on whether you’ve adopted an aggressive or conservative strategy.
Pullbacks offer opportunities for both short- and longer-term investors who can identify them. They can invest in a stock and profit when the price moves upward again.
Just be careful not to mistake a reversal for a pullback. If you can determine the likely causes of the pullback (see prior section), that may give you a better sense of how long- or short-lived the drop in price should be. For instance, if the company just filed for bankruptcy, you can bet you have a reversal and not a pullback on your hands. If you believe the company will thrive after it comes out of bankruptcy, you might eventually want to buy its stock. But not just yet. That price is headed much lower in the short term.
What is a healthy pullback in stocks?
A healthy market pulls back. It includes enough selling to entice buyers to jump in at lower prices. If no pullbacks occur, the only option for buyers is to pay higher prices. Fear of missing out (FOMO) often makes them do just that, but chasing a rising stock price can prove costly if a reversal follows.
Waiting for a healthy pullback can be safer. But how do you identify a healthy pullback? To do that, you’ll need to know about a key indicator traders use.
That indicator is the moving average (MA). Actually, this is a bunch of indicators, since you can have a moving average over any time span. You can also choose between simple and exponential moving averages. To identify a healthy pullback, you’ll need to use the simple moving averages for 20 days, 50 days, and 200 days — 20 MA, 50 MA, and 200 MA, respectively.
A pullback that remains above the 20 MA is said to be strong. One that remains above the 50 MA, but not necessarily the 20 AM, is healthy. And one that remains above the 200 MA, but not above the 20 MA and 50 MA, is weak. Strong and healthy pullbacks suggest upward trends that will continue. Weak pullbacks indicate the upward trend might continue but might not. Every trend, no matter how strong or healthy, can potentially reverse, but reversals are much more likely the weaker the trend.
Consider professional wealth management when you hit it big
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- A pullback is a short-term, temporary drop in the price of a stock during a longer-term uptrend.
- There are technical indicators for investors to consider when buying stocks during a pullback.
- Pay attention to earnings reports. These will help you recognize when a company is having issues.
- Patience is a virtue. Never let FOMO drive you to buy a stock before you’re certain it’s the right move.
- When a pullback breaks through support, it has the potential of becoming more than just a pullback. It could be a long-term reversal. Consider stop-loss orders to avoid catastrophic losses.
- Take great care to avoid traps the market sets for overly eager bulls and excessively dour bears.
- Don’t let market myths spoil your success as an investor and trader.
- If you are certain you want to be an active trader, consider the forex market. Trading world currencies can be a profitable endeavor for a skilled technician.
View Article Sources
- Encyclopedia of Candlestick Charts — Thomas Bulkowski
- High-speed Trading: Is It Time to Apply the Brakes? — Wharton School, University of Pennsylvania
- QUANTS: Meet The Math Geniuses Running Wall Street — Business Insider
- 6 Biggest Stock Market Myths Busted By Experts — SuperMoney
- Bear Trap: Stock Market Investing for Beginners — SuperMoney
- Bullish vs. Bearish Markets — SuperMoney
- How To Read Candlestick Charts — SuperMoney
- What is a Bull Trap in Stock Market Investing? — SuperMoney
- What is a Dead Cat Bounce in Stock Investing? — SuperMoney
- What is a Stock Float? Examples of High Vs. Low — SuperMoney