Decoding Pullback Trading

If you have to describe the stock market in one word, you would most probably describe it as ‘volatile’. Although investments in the stock market are based on detailed fundamental and technical analysis, there is no telling when the market will suddenly rise or fall. You may read all the charts, analyse all the patterns, and formulate various strategies, but there will be several instances when the market will move beyond your expectations. In this article, we’ve attempted to explain the pullback strategy in detail. Read on.

Let’s start with what is a pullback

Pullback, also referred to as price correction, is defined as a price movement, which moves against a trend. It is essentially a pause or slight drop in a stock or commodity’s pricing chart from the recent peaks occurring within an ongoing trend. The price movement is temporary and recommences back into the main direction of the market after a short duration – typically a few sessions, after which the uptrend resumes. A pullback is quite similar to consolidation or retracement and usually occurs when the prices of securities move at least one bar against the trends’ opposite direction.

Decoding pullback trading – what does it tell us

Typically, a pullback is viewed as a buying opportunity, after a stock, commodity or any other trading instrument has experienced a substantially large upward price movement. For instance, the price of a stock may increase significantly after a positive earnings announcement made by the company offering the shares. After a few sessions, the stock may start experiencing a pullback as traders begin to exit positions, after taking their profits off the table. That said; the positive earnings serve as a fundamental signal, suggesting that the stock will recommence its uptrend.

Note that before the uptrend resumes, most pullbacks involve a stock’s price moving into a technical support area, like a pivot point or a moving average. As a trader, you should keep an eye on these key support areas, because a breakdown from the support areas could signal a reversal trend instead of a pullback.

The different strategies of pullback

Having explained what pullback trading is, let’s take a look at the different strategies.

1. The breakout strategy

It’s regarded as the most common strategy; breakout pullback commonly occurs at market turning points. It includes the price breakout of consolidation patterns such as head and shoulders, triangles, rectangles and wedges. While employing this strategy, it is essential to remember that moving a stop loss so that can you break even, can be quite unprofitable, not to mention dangerous, because breakout pullbacks occur quite often.

2. The horizontal steps strategy

The horizontal steps strategy is defined as the natural rhythm of price, which showcases the ebb and the flow of market behaviour. The stock price often presents the stepping patterns during ongoing trending phases. This strategy nicely complements the breakout strategy. While the breakout pullback happens exceptionally close to the market’s turning points, if you miss the first entry opportunity, the horizontal steps can enable you to find alternative entry scenarios while the trade continues to progress. You can also employ this strategy to pull stop loss behind the trend, safely, by waiting until the price completes a step and then pulling the stop loss behind the previous pullback area.

3. The trend-line strategy

Trend-line is another popular strategy for a pullback. It requires three contact points to be validated. As a trader, you can connect two random points; however, a trend-line occurs only when you find a third point to connect. As such, the primary disadvantage of the trend-line strategy is that it often takes quite long to be validated. Also remember that the trend-line pullback may be traded only at the third, fourth or fifth point of contact. For a trend-line pullback to be implemented correctly, you can pair it nicely with other strategies. If you chose to employ this strategy as a standalone method, you might end up missing several opportunities, since trend-line validations typically take a long time.

4. The moving averages strategy

This one is regarded as the most implemented strategy in technical analysis; it can be employed in several different ways, including pullback trading. As a trader, you may use 20, 50 or 100-period moving averages, depending on whether you are a short or long-term trader. Short term traders typically use shorter moving averages. However, these averages are usually more vulnerable to wrong signals and noises. Conversely, long-term moving averages move slowly in comparison to short-term averages, but they are much less susceptible to noise and false signals. However, if you are not a frequent trader, you may miss short-term trading opportunities.

5. The Fibonacci strategy

The final pullback is known as the Fibonacci strategy. Fibonacci levels work exceptionally well in the financial markets. As a trader, you can use this strategy for pullback trading as well. To leverage this strategy, you must wait for a new trend to emerge. Once the trend emerges, you can draw the A-B Fibonacci tool from the point of origin to the trend wave’s end. You can then use the Fibonacci retracement’s C-point to pullback. You can also effectively combine the Fibonacci pullback strategy with the moving averages strategy. Also, when a Fibonacci retracement falls back into the same place with moving averages, you can leverage high probability pullbacks.

Final note:

A stock market is indeed an excellent place in which you can create wealth. As a frequent trader, you must familiarise yourself with the various share market jargon, terminologies, and strategies. As is apparent, there are several pullback strategies that you can approach and even combine. If you have only recently started trading, you can contact your investment advisor to help you understand the various strategies. For more information, reach out to an Angel One expert.