A pullback is a dip or mild decline from recent peaks in a stock or commodity pricing chart that takes place during an upswing. The phrases “pullback” and “retracement” are sometimes used interchangeably since they are so similar to each other. The phrase “pullback” is typically used to describe price declines that last only a few sessions, for example, before the uptrend returns.
How can we use pullbacks to our advantage?
After a security has seen a significant upward price movement, pullbacks are sometimes viewed as buying opportunities. For instance, a stock may enjoy a large surge after a strong earnings report, followed by a pullback as traders with open positions take the profit. However, the strong results are a fundamental hint that the stock will resume its upward trend.
The majority of pullbacks involve a security’s price moving to a technical support level, like a pivot point or moving average, before continuing its upward trend. A collapse from these important levels of support could indicate a reversal rather than a retreat, so traders should keep a close eye on them.
Typically, pullbacks don’t alter the fundamental story that is underlying the price movement on a chart. They typically present possibilities for profit-taking after a significant price increase in a security. For instance, a corporation may announce astronomical earnings and experience a 20% increase in share price. The following day, as short-term traders secure their gains, the stock may face a pullback. The stock’s underlying company seemed to be doing something right, though, based on the positive earnings report. Strong earnings reports will probably draw buy-and-hold traders and investors to the company, fostering a long-term rise in the near future.
Examples of pullbacks within the framework of an extended uptrend may be seen on any stock chart. While these pullbacks are simple to see in hindsight, for investors holding a security that is depreciating in value, they may be more challenging to evaluate.
Possible disadvantage of pullbacks
Reversals and pullbacks both entail a security falling away from its highs, but reversals are more sustained. How therefore can traders tell the two apart? The majority of reversals entail some modification to a security’s fundamentals, which forces the market to reassess the security’s worth. The net present value of a stock, for instance, might need to be revised by investors if a business announces dismal profits. Similar to that, it may be a bad settlement, a brand-new rival releasing a product, or some other occurrence that will have an extended effect on the business that underlies the stock.
These occurrences, which, in a sense, occur outside of the chart, will arise over the course of several sessions and initially resemble a pullback. For this reason, traders signal when a downturn persists and is in danger of entering reversal territory using moving averages, trendlines, and trading bands.
The biggest drawback of trading pullbacks is that they may signal the beginning of a real reversal. One trader’s multi-session retreat is actually a reversal for a day trader looking at the same chart because both pullbacks and reversals occur on a variety of timescales, including intraday if you want to get specific. If the price action breaks the trendline for your timeframe, a reversal rather than a pullback may be in store.
It is not the right time to take a bullish position in this situation. Of course, including additional technical indicators and fundamental data scans will boost a trader’s confidence in differentiating false reversals from pullbacks.
Using moving average in conjunction with pullbacks
Without a doubt, moving averages are among the most popular tools in technical analysis and they are used in many ways. And you can also use them for pullback trading as well.
You could use a 20, 50 or even a 100-period moving average. It doesn’t really matter and it comes down to whether you are a short-term or long-term trader. Shorter-term traders generally use shorter moving averages to get signals quicker. Of course, shorter moving averagers are also more vulnerable to noise and wrong signals. Longer-term moving averages, on the other hand, move slower, are less vulnerable to noise but also may miss trading opportunities in the short-term. You have to weigh the pros and cons for your own trading.
Using trend lines to locate pullbacks
Trendlines are a well-known pullback tool as well. The disadvantage is that trendlines frequently require more time to be validated. A trendline needs three contact points to be authenticated, as we have seen in our guide to trendlines. Any two random points can be connected, but only when you reach the third do you truly have a trendline in front of you.
Therefore, only the third, fourth, or fifth contact point can be used to trade the trendline pullback.
Trendlines can complement other pullback strategies well, but when used alone, a trader may miss many profitable opportunities if the trendline confirmation takes a long time.