Why Trade at Pullback? Just imagine if we can tell exactly when a trend starts and ends, hence trend trading will be so much easier. All we have to do is to buy early at the beginning of the trend and sell when it ends. Obviously things aren’t as simple because we don’t have a time machine to tell us the exact information. The next best thing we can do is to buy into pullbacks on uptrends and sell into pullbacks on a downtrend.
Why? If we have intention of buying, we would want to do it at the lowest price possible, and pullbacks allows us to do that. Also, it is also possible to monitor some characteristics of the ongoing pullback to get some idea where trend might end.
Characteristics of Winning Pullbacks
Pullbacks are basically contra-trend movement (opposing trend) to the main trend. For example, in an uptrend chart is accompanied by a downtrend price pattern in a lower time frame.
BUT, the contra-trend in a lower time frame tends to be weaker and also tends to stop suddenly. This is due to the higher time frame trend reasserts itself. So by understanding this principle, we can filter out lower probability trades in a pullback setup. For example, if we have a strong uptrend in a time frame and we check the lower time frame but noticed a strong down trend, that is a lower probability trade.
A lower time frame is to have weaker contra-trend movement (which signifies the pullback to the longer time frame) and it ends suddenly.
The chart below shows a pullback in a good uptrend on a Daily US Dollar Index Future on the left side. This is the second pullback off a potential trend change in early November while the market rallied above the upper Keltner channel. It also pullback around the moving average as well. This normal would signal a good uptrend long position.
However, on the right lower time frame chart shows a very strong downtrend on a weekly chart. So the smaller time frame Daily Chart has a strong uptrend movement which conflicts a strong downtrend on a Weekly Chart. Hence, the uptrend on the Daily Chart is very likely to end and resume downtrend.
In a way, if we are trend trading on a certain time frame, always check the higher time frame chart to confirm a trend there too. If you see a strong downtrend in a lower time frame chart, we want to have a downtrend on higher time frame too. This way, statistically speaking we’re following a larger driving force of the trend.
Follow Good Momentum or Impulse
There are many ways to quantify this, firstly we can judge visually on the price chart. Else, we can also use momentum or MACD indicator to help with calculating the swing. Obviously this can be quite subjective and varies from trader to trader. Nevertheless, it improves overtime with experience.
The important question is to ask “Are we seeing a move that should have a continuation?”.
We should lookout for sharp impulse movement and for significant momentum moves that signifies imbalance in the market. Which will usually resolve by price movement in the same direction.
Lets check out the price chart below that is accompanied by a modified MACD indicator to confirm momentum.
Point A marks a significant high based on the MACD indicator relative to its recent history (not visible to the left of the chart). This would suggest as an opportunity to buy into a weakness of this impulse movement. The aim is to look for another drive to the upside and the pullback slightly to the right offers that opportunity.
At Point B, the market made a new high that follows the previous large impulse movement at point A. However, the MACD at point B did not register a new high. This is known as Momentum Divergence. It is a bad idea to enter a trade at the next pullback following a Momentum Divergence. In this case, the market did make a new high but only to move sideways after that.
At point C, the market makes a new high and so as the MACD. So we’ll be looking to enter at the next pullback. At point D, market once again makes a new high but MACD doesn’t. So we won’t be entering at the next pullback due to another momentum divergence.
At point E, there is a sell-off that occurs which caused a massive downward movement in price as well as MACD. It would signal an opportunity to short at the next pull back. At point F, another momentum divergence spotted. Once again, we should not sell at the pullback following that.
Although there is valuable information in the size and character of a pullback, but noise in the market makes exact measurement and ratio not really useful. Nevertheless, a strong trend tend to generate smaller pullbacks relative to the with trend leg.
Generally, a typical retracement can terminate in between 25% to 75% of the range. However, don’t be surprised termination of retracement to be shallow or extra deep.
Shallow retracements are more common in intra-day charts than higher time frames. Sometimes strong trend are unable to pullback at all! This would be very different from the typical trend pattern, which is a pattern by itself.
Prices may move higher up in a series of tight, stair-step trading ranges or they press against the upper channel. This is a very difficult pattern to trade since there is no obvious pullback for entry. Even though there is an obvious sign of imbalance of buyer seller forces.
Common Characteristics of Failed Pullbacks
One common pullback failure pattern is when the market to looks like a good pullback but there is no move out of that pullback. Instead the market went into a flat range signifying buyer and seller in balance.
Trading in this range would be a bad idea because it often produce a random price movement within that range. More importantly, it is not driven by any imbalance in forces. ALSO, breakout from this range is super annoying because it could be a fake-out in either direction!
The best thing to do when we identify a flat pullback is to minimize your losses or just book in a smaller profit and close the position. It would have been better to deal with it this manner rather than be stuck in a position of uncertainty.
Sharp Countertrend Momentum as Pullback is Violated
Some of the most dangerous pullback failures in terms of potential loss is when the pullback fails sharply by breaking into the ‘wrong direction’. For example a pullback that is anticipated to have continuation towards uptrend may fail through sharp breakdowns and vice versa.
Risk management in this situation is quite tricky and would be best to manage your profit/losses. Although this failure pattern may be really bad for people anticipating a trend continuation by enter a pullback. There is an opportunity for traders that aims to enter a reversal after this sudden sharp movement.
It really depends on how you want to manage your trades though. Your focus should be minimizing your losses and managing your portfolio if you have taken a position and its’ losses is pilling up. Else, you may just access for another opportunity by watching for potential reversal. (After referring to higher time frame for potential imbalance in buyer/seller forces).
An example of such a situation are as below. The consolidation has failed due to two bearish candles that break the pattern at A. However, there is no more selling conviction after that point and price bounces back up.
Failure around Previous Pivot Level
It is unrealistic to expect every pullback will result into a new trend leg equal to the setup leg. Of course that will be the best case scenario for all trend trading. But it is more common to find pullback trades with opportunities for smaller profits.
More consistent results will come from taking at least partial profits at a more conservative profit target; the pivot high or low (in uptrend and downtrend respectively) of the setup leg. And traders do manage their trades this way.
Read our Introduction to Trend Trading if you find this article to be a little too confusing!
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