One of the ways to succeed in trading is to predict the market by thinking “ahead of the crowd”. When doing this an uptrend can mean a selling opportunity. A downtrend can mean a buying opportunity.
In forex, as with other markets, trends rarely move in straight lines. A pullback happens when the market exhausts its current cycle of buying or selling. In an uptrend, the last gasp is often the time the least informed traders are buying in. The reverse is true in a downtrend. Here the least informed traders are typically selling out near the bottom.
For this reason pullbacks can create some great entry points for tactical buying or selling.
How to Trade the Pullback
There are two ways to trade pullbacks and these are generally used by traders with very different time horizons – tactical or strategic. The strategic (or long term) trader will use the pullback as an opportunity to enter the trend. They will buy on the dips and sell at the peaks.
On the other hand, the tactical trader will try to predict when the pullback is about to start. They’ll then buy or sell to into the correction itself. Tactical traders are assuming that some mean reversion is likely to happen as the price gets further from fair value and this will trigger the pullback.
Market Dynamics
As well as factual information like news reports, markets are governed by the laws of supply and demand. They’re driven by the quirks of human emotion as well. For these reason, markets tend to move in cycles. This happens as sentiment swings back and forth from optimism to pessimism, bullishness to bearishness.
At whichever time scale you look, market dynamics appear to work in this same way. In other words, markets have fractal like properties. Fractals are mathematical patterns that repeat their structure at different scales.
This fractal nature of markets has been used as the basis for technical tools like Elliott and Zig Zag pattern filters. It’s also the idea behind more specialized fractal analyzers that try to find structure within a chart.
How to Locate Pullbacks
So how does this knowledge help us predict when a pullback will happen? Correct timing is essential to a short term tactical strategy. If the trade is entered early, before the pullback forms, you risk being positioned on the wrong side of a trending market. If the trade is put on late, the profit potential is reduced and there’s a chance of being caught on the wrong side as the pullback reverses on itself.
Luckily there are a few tools that we can use to objectively estimate the probability of a pullback taking place.
Overbought/oversold indications
Chart oscillators like MACD, and RSI work on the above assumptions about market dynamics. That is that markets tend to move in repeating cycles. We can use these as a guide as to when the market is likely to be reaching a tipping point where bullishness turns bearish or the other way around.
Using an oscillator like MACD alongside the Zig Zag filter (see below) can be extremely useful. This helps in spotting whether a trend wave is nearing the end and is due for a corrective pullback.
The MACD is very easy to use. It is simply the difference of two moving average indicators. The output tells you the rate at which momentum is changing over time and it highlights overbought and oversold levels.
Zig Zag and Elliott Wave Filters
Zig Zag and Elliott wave indicators will mark out on the chart where pullbacks have already happened. Zig Zag comes as standard with the Metatrader terminal. Elliott wave detectors are freely available.
Both of these filters are highly effective at identifying the critical chart areas like trends, cycles, tops, bottoms as well as support and resistance. Without a visual reference these patterns can easily be lost in the “noise” of the chart.
The chart above shows the Zig Zag filter as it marks out the important turning points. The probability estimates shown here are from our own pullback detector. These are calculated by using the overbought/oversold state at each given candle in the chart.
Once an entry point is decided, we use the depth of the last pullback and nearby support/resistance lines to set the stop loss and take profit.
Pullbacks That Don’t Happen
One of the most frustrating things about trading a pullback strategy is when the market fails to turn when you expect it. This is every bit as challenging as the problem of false breakouts.
Sometimes, all of the indications will point towards the market being overbought or oversold. The trend cycle might look to be over extended. Yet it keeps on going.
If you’ve already entered the trade at this point this is bad news because you’re on the wrong side of the market.
The chart below shows an example of how this can happen. Here GBP/JPY shows a newly forming trend moving into overbought territory. The indicators start to predict a pullback forming about two thirds of the way up. The earlier reversal point also suggests this could be a resistance level too.
As shown in the chart this trend does extend on further.
Obviously, waiting for a pullback to develop before entering can mean giving up some profits. It’s also not without risks. There’s no guarantee that the market won’t turn the other way again after the trade is placed.
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Strong trends are especially likely to extend much further than seems logical. When using a pullback strategy, this effect has to be allowed for. Trends with high momentum often extend well beyond fair value as the late buyers or sellers jump in because they fear missing out in a fast paced market.
Eventually the trend may then develop into a head and shoulders pattern or simply correct itself once the buyers (sellers) run out.
Pullbacks as a Day Trading Strategy
The pullback strategy I’ve explained here tends to work better on the longer timeframes. The four hour chart and the daily chart are good choices. Patterns at the lower timeframes are prone to more noise and are much harder to forecast.
With the four hour chart, this can be an effective day trading strategy. Each trade usually lasts on average one to three days.