For the long-term trader a pullback can create the opportunity to buy low, and sell higher or to sell high and buy lower.
Of course, this depends on reading the chart correctly.
But as many traders soon learn, pullbacks can be a killing-ground that trap the unwary on the wrong side of the trend and lead to rapid losses.
Sentiment of the Pullback
Trends and pullbacks go hand in hand with one another. As sentiment swings back and forth from optimism to pessimism, so does the direction of price. This can often result in the market overshooting or undershooting. It is these places that best pullback opportunities come about.
To identify a pullback, we first need to know where the average trend is and how the market is reacting at that instant in time.
For example, in a strong bullish trend the price will typically rally to a new high, test the resistance and then fall as momentum starts to drop off.
Even before momentum slows, experienced traders are already anticipating the pullback before it begins. In addition, of course some use the top as an opportunity to sell out. This is the lifecycle of a short term pullback.
Simple Pullback Trading Strategy
First, place the Bollinger band indicator on to the chart and choose a period and deviation so that all but the extreme points are inside the bands. A period of about 20 chart bars and 2 deviations is usually a good point to start.
The center line of the Bollinger indicator will now show the moving average of the trend. The bands and the center line should now delineate any pullbacks as Figure 1 shows.
These examples are of course historical but from them we can identify the characteristics of a pullback/continuation versus a trend reversal.
The first thing to confirm is that the market is trending in a certain direction rather than ranging. Figure 1 shows a segment of the EUR/USD daily chart. In this date range, the trend turns from bearish and then to bullish.
We can spot some characteristics of a typical pullback
- The price breaks new lows or highs and touches the outer Bollinger band
- At reversal the price crosses back to the center line, the moving average
- In a bearish trend, the pullback high doesn’t reach above the last one
- In a bullish trend, the pullback low doesn’t reach below the last one
Most pullbacks tend to be short and sharp with a clearly defined reversal point.
If a pullback extends in a broader correction then we give this more caution. If it breaks higher or lower than the last reversal that is a sure sign that the trend may be reversing. In the EUR/USD chart, we can see this happening at the black vertical arrow where the trend turns from bearish to bullish. This is the reversal point.
From the direction of the moving average line, we confirm that downwards momentum is slowing here already before the reversal starts. The MACD divergence confirms this before the pullback begins – Figure 2. Going short here on anticipation of a pullback would clearly not be a good idea.
Trade entry timing
The most common strategy for trading pullbacks is to go in the direction of the trend. Here we time the entry to maximize the swing back to the trend.
For a swing trader, entry and exit timing as well as fill price is everything on trading the pullback. Get this wrong and the profit can easily turn the other way and become a loss. For a trend follower, this timing is not so critical.
Only enter the trade when there is clear enough evidence that the pullback is completing. This usually requires at least two or three bars at the reversal point that are moving in the direction of the trade.
A simple way to do this is by creating a stop order with your broker. The timing of the order and the stop price is set to execute only if the pullback duly reverses back to trend.
Otherwise, the stop order expires unfilled. Expiration occurs if the pullback extends further and does not reverse within the timeframe specified. This happens for example, in Figure 1 at the third bearish pullback.
In a bullish trend, the price action is likely to bunch in the top half of the Bollinger band. In a bearish trend, it bunches in the lower half. We can use this pattern in deciding stop losses.
If the price extends for any time into the opposite territory of the Bollinger band to which you are trading, it is usually best to close out.
A good stop distance is roughly half way between the entry price and the opposite band level to which you are trading. For example if we sell to open in the third bearish pullback in the chart above at 1.0540, the stop would be around about 1.0640. For a short sell, the profit target is the bottom of the band, in this case around the 1.0315 mark.
Knowing Which Pullbacks to Avoid
As pullbacks are extremely common, the question is which to trade, and which are best avoided. Not all are worth trading because the profits can be too small.
As with any trading strategy, using other confirmations helps to decide between pullbacks that could lead to a quick profit and the rest.
One way to confirm a pullback is by using known technical patterns. Most pattern types are either continuation or reversal. Figure 3 shows the chart is making an ascending triangle continuation pattern.
The existence of a continuation pattern, rather than a reversal pattern can then help to validate the trade entry. They are not always present but when they are, they can offer valuable insight into the state of the market.
The downside is that waiting for confirmation patterns does delay entry into the trade. In addition, due to the randomness of markets, there is no confirmation that will be accurate one hundred percent of the time.