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The
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The SortWizard Resource Center
The SortWizard ®
Stock Screening Software
The SortWizard Resource Center
Trading Pullbacks
By Dave LandryTrading pullbacks--pauses or temporary reversals in ongoing trends--can be a low-risk, high-profit-potential strategy if approached properly. Here, we will discuss how trends and pullbacks form, how to identify good pullback candidates, and how to execute trades on these patterns. For simplicity, we will frame our discussion in terms of uptrends, but the concepts are equally applicable to downtrending markets
1. Trend dynamics
There is nothing mysterious about how trends form. When investors and traders become interested in a stock of future, for example, price begins to rise as these buyers bid the market higher (as demand exceeds supply).
The initial rally attracts the attention of more traders who jump into the market, afraid of being left behind. This process extends itself until there are no more buyers left to enter the market.
It is not advisable to buy any stock or futures simply because it is rising--trends do not last forever. Sooner or later investors begin to take profits, and the "weak hand" traders who bought late in the trend and have very little staying power (i.e., money and patience) may panic and dump their positions. Finally, short sellers (those who look to profit by betting a market will drop) may enter the market.
All these factors combine to cause corrections, or pullbacks. The problem is you never know when these natural occurrences will happen and possibly take you out of the market. Therefore, your chances of staying in a trade are improved by entering after a pullback has occurred.
Identifying pullback candidates
An important part of the pullback strategy is to use it in strongly trending markets. One way to do this is to look for stocks with high relative strength (RS), a measure of how an individual stock is performing relative to its group or sector. The stronger the performance of the stock compared to its sector, the higher the relative strength reading.
There are several sources for this information. For stocks only, you can use the Investors Business Daily’s Relative Strength (RS) rankings or TradingMarkets.com’s Interactive RS Investigator; for stocks and futures, you also can use TradingMarkets.com’s Proprietary Momentum lists or the New Highs On Double Volume lists.
The next step is to wait for the stock or future to pull back. A good rule of thumb is to wait for a market to go at least three days without making a new high. This allows sufficient time for the natural selling we discussed earlier to take place.
Figure 1. A Pullback. Notice that after the making a new high, the stock began to sell off. Also notice that the sell off is between 5-15% from the preceding new high.Also pay attention to the size of the pullback: Look for a sell-off of 5-15% from the high see Figure 1). This allows for the losses of long position holders to become big enough that they to begin to question their trades. The pullback cannot be too deep, however. If it exceeds 20% it may be a sign the uptrend is over and a downtrend has begun.
Essentially, pullbacks should be deep enough to flush out the weak hands but not deep enough to be categorized as a new downtrend. Also, corrections tend to be deeper in volatile markets that attract fast money, requiring a looser pullback definition. For example, a deep correction in a hot Internet stock is more acceptable than one in a consumer cyclical issue.
Entering the market
After you identify a pullback, the question is how to enter the market. The best way to is to wait for the stock to pivot back into the direction of the uptrend. But remember, just because a strongly trending stock has begun to pull back does not mean the uptrend will resume. What appears to be a correction may turn out to be a complete reversal (see Figure 2).
Figure 2. Failed Pullback. What initially appeared to be a pullback turned out to be the start of a new downtrend.A useful technique in these situations is to place your order above the market (see Figure 3). This ensures, at least temporarily, that you are entering the market in the direction of the larger trend. Also, it will keep you out of the market if the pullback is really the start of a larger decline.
Figure 3. Pullback Entry. By placing your order above the market you ensure the trend has turned back up and the pullback is not the start of a larger down move (as in Figure 2).Risk considerations
No strategy is complete without a risk control plan. Although placing your order above the market helps ensure the market is moving (at least temporarily) in your direction, it in no way guarantees a pullback is complete and the market will resume its up trend in full force. As a result, it is necessary to protect yourself with stop order.
The most logical place for a protective stop is below the lowest bar of the pullback. If the move turns out to be a much deeper correction, or the beginning of a new downtrend, you will be stopped out with only a small loss. Professional traders are willing to take several "stabs" at a market, risking very little each time, in the hope of capturing a larger move.
Figure 4. Protective Stops. Place a protective stop below the low of the pullback low. This allows you to risk a minimal amount of money if the pullback turns out to be the beginning of a larger correction or down trend.The best way to become successful is to study success. Figures 5-7 provide a few illustrations of successful pullbacks. All the examples show strongly trending markets in which pullbacks offered multiple opportunities to enter the market with limited risk.
Figure 5. Micron Technology. Notice the pullbacks (down- sloping lines) and the moves that followed them.
Figure 6. Amazon.com. Stocks in hot sectors tend to make good pullback candidates.
Chart 7. Sanmina Corp.By Dave Landry
The trading setups and strategies are intended for educational purposes and only for demonstrating SortWizard usage. Those who act in accordance with the contents and suggestions of this document are acting on their own. Each user of the setups is entirely responsible for his or her own actions, if any. The user understands there could be errors in the setups and in the SortWizard software that could produce erroneous results. The use of any of the supplied information, files, strategies, software, and etal supplied to you from anywhere in this web site, materials supplied to you from any other source and/or your reading of this document constitutes that you are in agreement with this disclaimer and exempts the author(s), IPS Technologies, Inc., and Neo Inc. from any liability or litigation under any circumstances. If you do not agree with this disclaimer, it is the user's/reader's responsibility to refrain from taking action on anything detailed within this or any other document(s) referred to.
