Trading
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
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.
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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.
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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).
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Figure
2. Failed Pullback. What initially appeared to be a pullback
turned out to be the start of a new downtrend.
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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.
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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).
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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.
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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.
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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.
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Figure
5. Micron Technology. Notice the pullbacks (down- sloping lines)
and the moves that followed them.
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Figure
6. Amazon.com. Stocks in hot sectors tend to make good pullback
candidates.
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Chart
7. Sanmina Corp.
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By
Dave Landry
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