Every trader knows the adage “the trend is your friend.” In other words, you have a higher probability of success if you go with the market’s flow rather than fight it.
However, buying breakout stocks, or those experiencing a sharp upward movement in price, would seem to go against another adage—“buy low, sell high”—even when the trend fully supports further appreciation.
So, what’s a trader to do? I often encourage newer traders to consider an alternative strategy: the pullback trade.
How to spot a pullback
As its name suggests, a pullback is a stock’s short-term move in the opposite direction of the longer-term trend—which can offer an opportunity to join an uptrend at a relatively advantageous price (see “Anatomy of a pullback trade,” below).
Of course, you’ll first need to determine whether the price drop is a pullback rather than an outright reversal. You can never know for sure, but here are a few flags I look for when scouting for pullbacks:
- Volume: You want to see a drop in trading volume when the price pulls back. If instead volume picks up, it could be an indication that sellers are gaining power and that the price will continue dropping.
- News: I also double-check to make sure that earnings or other significant news isn’t in the offing. Such announcements can cause a dip that isn’t an anomaly but rather is based on real-world events.
- Support: Most important, I will look to see what happened during the previous trading days. I like to see the stock pull back to a logical level of support—like an old low or the moving average—where buyers are likely to find the price attractive. A stock that falls below these levels is at greater risk of continuing to drop.
Finally, you want to be sure the stock resumes its uptrend, or begins trading above the previous day’s high, before you make your move. Waiting for the stock to re-achieve that mark has saved me more times than I can count.
How to trade a pullback
Once these conditions are present, it’s time to enter the trade. If you’re constantly monitoring the market, then you can buy the stock at its market price as soon as it exceeds the prior day’s high.
But if, like me, you’re not sitting in front of your screen all day, you may want to place a stop-limit order. For example, let’s say you’re interested in buying a stock with a previous day’s high of $37.50. You could place an order to buy shares at a $37.60 stop and a $37.85 limit. If the stock opens lower than $37.60, you won’t own the shares until it reaches that number. However, if the stock opens higher than your limit, you won’t be stuck with a bunch of shares at a price that could make it tough to turn a profit.
When to exit a pullback
For a stock to keep trending higher, it has to make ever-higher lows along the way. So when the price dips below the prior low established during the pullback, there’s a greater chance the uptrend may be over. Placing a stop order to sell the stock just under the low of the current pullback is a good way to minimize your downside.
If the stock resumes its uptrend, I generally have two targets:
- The first is the previous high before the pullback, as old highs are often a ceiling the market can be reluctant to breach. At this point, I’ll often sell some of my position in an attempt to take a small profit and raise my stop to my initial entry point on the remainder.
- The second is based on what is called a measured move, or the distance between the most recent low and the most recent high prior to the current pullback and the most recent high prior to the current pullback. If you add that amount to the low of the current pullback, that target price should net you a tidy profit were the stock to resume its uptrend.
In any case, I usually won’t exit my full position at that second target. Success in trading is about minimizing your losses and maximizing your gains, and you may want to give yourself room to capture an even bigger move.
Familiarity breeds confidence
Pullback trading is more art than science. Stock screeners can help—by identifying candidates that have recently pulled back to their 20-day moving average, for instance.
In any event, pullback trading can be a great strategy for dipping your toe in the water. And the more experience you gain from researching and executing such trades, the more comfortable you’ll feel braving the rapids.
What You Can Do Next
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