A plan to trade pullbacks is one of the very best solutions to make the most money from trend following strategies.
Just imagine that you want to trade a trend in the most efficient manner possible.
If you could know the future, when and where the trend will begin and end, it would be so simple:
- Simply buy at the beginning of the uptrend and sell at the end;
- Just do the opposite in a downtrend: short at the beginning of a downtrend and cover at the end.
As Amazon.com does not sell time machines yet, we have to find another plan.
By using pullbacks to enter for the next trend leg, the trader is 100% sure to position for a very low risk/highly rewarding trade.
In other words:
- Buy into the pullbacks in uptrends,
- and short into the pullbacks in downtrends.
Even if we keep buying in an uptrend, we always prefer to buy on pullbacks.
It’s simple: Do you prefer to buy at relatively low prices or at high prices?
A plan to trade pullbacks relies on some of the most reliable statistical tendencies in the markets: odds go for continuation out of a trend AFTER a pullback.
This is the reason why trading pullbacks offers such an amazing risk/reward ratio.
To trade pullbacks is not easy but it can be taught.
It requires strong skills… in particular:
- to understand what is a pullback,
- to identify simple from complex pullbacks,
- to recognize winning from failing pullbacks,
- finally, to be patient enough to stalk for the best entry…
Let’s carry out some research together first while sharing a noteworthy tip for a plan on how to trade pullbacks successfully.
Table of Contents
Breakdown on how to trade pullbacks
Why should we trade pullbacks? Because Price NEVER moves in a straight line.
If you have been following us for a while, you should know by now that market price never moves in a straight line.
In fact, the opposite is true: market price always moves up and down even when there is a clear trend.
This phenomenon is known as a price cycle.
Like it or not, this is true for all markets and all market conditions including the trending, reversing or sideways market.
Because the market is similar to a living organism.
Like a living being taking a breath, the market continually expands and contracts.
The sum of these rallies and declines form the cyclical patterns of the price that exist in every timeframe, from tick chart to a yearly timeframe and more.
And obviously, trading pullbacks offer a great location for our trade entries, along with a high risk to reward ratio.
The pullback is only represented by price movement between point B and C.
However, for the sake of completeness, a pullback (BC):
- must remain between A and B,
- must include a leg between C to D, where D moves beyond B.
If not, that would be considered a failed pullback.
You will find more explanations about failed pullbacks later in this post.
A pullback’s definition
After a normal impulsive move, the market will usually go into a pullback.
A pullback is a countertrend movement, with price moving against the direction of the main trend, that usually leads to another price movement in the direction of the original trend.
In other words:
- after an impulsive move up, the pullback will be a downward movement against that initial impulse;
- pullbacks in downtrends are bounces against the preceding downward impulse move.
As a consequence, a pullback is:
- a price movement that moves in the opposite direction of the primary trend,
- this temporary countertrend movement resumes in the main market direction later,
- and it does so by breaking beyond the recent price extreme. If price does not go beyond the recent extreme, then the pullback could reverse, or it could consolidate a bit more.
So basically, pullbacks are countertrend movements, meaning that:
- in an uptrend, the pullbacks are actually lower time frame downtrends,
- and, in the case of pullbacks in downtrends, the lower time frame will be in an uptrend.
Conceptually, the pullback is a natural consequence and reaction to the impulse move.
The pullbacks are sometimes referred to as dips, retracements, corrections or consolidations.
It’s logical for the market to take a break and consolidate the energy it requires to continue. This is exactly what it does during a pullback.
In order for price to go through it’s cycles, there must be a pullback.
Think about it, price needs to pull back before it can push forward.
And the repetition of pulling back and pushing forward is what contributes to a price cycle.
When the market is liquid enough, price will cycle in all market conditions, in any timeframe and any direction.
This must also mean that prices will make pullbacks in any market conditions, any timeframe and any direction as well.
Also, notice that one important principle of market behavior is that trends that run counter to the higher timeframe trend tend to be weaker.
They tend to abort suddenly as the higher time frame trend reasserts itself.
Keys elements to trade pullbacks successfully
The difference between simple and complex pullbacks
As a trader, you have to read price action cautiously to create order from chaos.
To master this art, use the pivots strategy to understand and trade efficiently the current market structure.
A simple pullback should be in the shape of an ABCD pattern.
Basically, price behaves as follows:
- The trend leg ends,
- the pullback begins,
- and, at the bottom of the pullback, buyers push the market to new highs.
Hence, they are usually fairly obvious and easy to spot.
Well, it is not always this simple.
In a complex pullback, price action tends to follow this pattern:
- The trend legs ends,
- The simple pullback begins,
- Then, buyers failed to push the market to new highs,
- So the pullback puts in a second leg.
As a consequence, the main difference between simple and complex pullback lives in the failed attempt to resume the original trend.
Because this attempt fails and rolls over, the pullback puts in a second leg against the primary trend.
As a consequence, a complex pullback is actually a complete trend leg (impulse, pullback, impulse) structure on the lower time frame.
We also commonly refer to them as two-legged pullbacks.
Any successful trend trading strategy has to account for the possibility of complex pullbacks.
Recognizing the two patterns is essential in order to trade pullbacks successfully.
As a trader, you have to understand these complex pullbacks for several reasons.
First, complex pullbacks are common. Trend traders will make the bulk of their profits in trends that extend for several legs.
Also, pullbacks in trends tend to alternate between simple and complex.
Another reason to understand these patterns is that many traders will execute a trading plan that is a variation of “entering into a pullback and exiting if the pullback continues to move against them”.
Complex pullbacks will stop these traders out of their positions as the pullback makes new countertrend extremes on the second leg.
Anatomy of the best and easiest pullbacks to trade
When you want to trade pullbacks in a trend, the question you should ask yourself are:
- “Am I in a trending environment?“
- “Am I seeing a move here that should have continuation?”
Winning pullbacks share some common characteristics:
- They follow a very strong impulsive move, and are not preceded by momentum divergence.
- They come after a large swing move in the very firsts legs of a price cycle.
The best pullbacks come with very high and healthy momentum
There are many ways to quantify this, but a simple visual chart analysis can be very useful.
The most important thing to keep in mind is that we are looking for sharp impulse moves.
For significant momentum moves that indicate there is an imbalance in the market that should resolve with another move in the same direction.
It is also possible that managing existing positions may require a slightly different mindset than initiating new positions.
For instance, a strong enough divergence could warn you not to increase risk or not to initiate new positions into the next pullback.
But you might still be justified in holding a partial position that was initiated earlier at better prices…
This is the kind of question that must be decided in advance, and your trading plan should encompass all the possibilities for managing existing positions as well as initiating new exposures.
A corollary to the preceding is that the best pullback trades will not come after a momentum divergence.
Well, it does not mean that you can’t trade pullbacks that follow a momentum divergence.
But their probability of success decreases because of the divergence.
There are both objective and subjective elements to this evaluation, but a simple MACD, ADX-DMI or RSI analysis is a good place to start.
If we precisely define the ways in which we will measure momentum, it is possible to define some clear guidelines for trades to be taken and avoided based on the existing momentum conditions.
If you are confused about this, check the first lesson of our ADX course.
The complete 4-video course is free and helps you to determine:
- when a trend is beginning,
- when the trend is strong enough to buy,
- when the trend is getting weaker,
- when the trend is ready to reverse,
- when the trend is entering consolidation.
The best pullbacks are the earliest in price cycle
Length of swing analysis provides some additional insight into the momentum behind each leg of the trend:
- Larger swings (vertical distance on chart) have stronger momentum than smaller swings,
- But the rate of the trend (price/time, visible as slope on the chart) is also important.
Location in trend really matters.
It is an axiom in technical analysis that the first entry in a trend is the best entry.
But this is an example of the kind of hindsight analysis that must be avoided.
All this really says is that if a market goes up, the best place to get in was at the beginning of the move.
Not a particularly helpful piece of knowledge.
However, this concept is useful from a slightly different perspective; with each successive trend leg we should be slightly more suspicious of the move.
It is hard to justify assuming the same kind of risk on the fourth or fifth legs as on the first or second…
But it is also important to remember that markets:
- do have outsized trend moves,
- and some trends go on far longer than anyone would have thought possible.
It is rare, but a market can have >5 trend legs in the same direction without a significant pullback.
Most of these later legs will be generating momentum divergences and then rolling over those divergences.
As important as it is to understand the patterns associated with successful pullbacks, it is equally important to understand the patterns that hint at impending failure.
Anatomy of failed pullbacks
If you want to succeed in trading pullbacks, you need to know how pullbacks fail.
So when it happens, you are prepared for it.
Once you learn to navigate the market through successful and failed pullbacks, you are certain to progress pretty far in your trading career.
As long as you practice good risk management.
Common characteristics of failed pullbacks
Understanding how patterns fail lets traders look for warning signs to exit losing trades, sometimes taking a smaller than expected loss.
In addition, some very good trades are driven by traders trapped in failed patterns.
In general, pullback trades fail in one of three ways:
- There is no momentum out of the pullback, and the market goes into a more or less flat trading range somewhere in the level of the pullback.
- The pullback fails dramatically as sharp, countertrend momentum emerges. The challenge is to distinguish between this scenario and the more common complex consolidation.
- The next trend leg emerges out of the pullback, but it fails in the neighborhood of the previous swing (i.e., the high of the setup leg in an uptrend or the low of the setup leg in a downtrend).
Understanding how pullbacks fail
As mentioned earlier, the terminology of a pullback only represents price movement from B to C.
You can check the pictures below to get the idea.
However, for the sake of completeness, a pullback must include CD where D clearly moves beyond B.
On the other hand, if C clearly moves below A, BC is no longer a pullback and that is the point where the pullback fails.
This does not imply that the market is going to start trending in the opposite direction immediately.
Many new traders assume that when the trending market ends, you’ll get a reversal market immediately.
Unfortunately, that’s not the case.
Because a failed pullback marks a break in the trend’s market structure.
We explained previously that a trend reversal is a three step process:
- First, a lower low is formed when the pullback fails: C breaks A level.
- After, price tries to resume the trend by taking out A but… fails again.
- And finally, price breaks the support at C level.
If price doesn’t break it, you are in a sideways market and probably in a time-correction (low volatility and trendless environment).
In effect, when a trend ends, there is a 50:50 chance that price would reverse into the new direction or it could start moving sideways.
In fact, if you get a sideways market, you could still find the market trending again in the primary direction at the end of the sideways market.
It is important that a break below point A shows conviction, because a convicted failure represents a market leader taking charge.
Yes, you got it, a failed pullback can fail.
It will create a swing failure pattern offering us an amazing trade entry.
It is not surprising that pullbacks can fail.
In fact, it is important that you know how and when they fail so that you are prepared for it.
"Measuring" the moves to trade pullbacks
Pullbacks as a measure of commitment
In fact, judging the commitment behind pullbacks is essential.
Maybe, it’s the most important component of reading the market tape.
If buyers are aggressively accumulating positions, then they will not let the market come in as much on the retracements.
They will step up and buy aggressively at higher prices.
In this situation, the market will mostly correct over time rather than price.
This is what we call a time-correction: market will digest the move in a horizontal, low volatility and trendless manner.
This will result in shallower, smaller pullbacks compared to a situation in which buyers are relatively more complacent and willing to wait for lower prices.
If buyers are more uncertain, they will demand lower prices as protection and will not be willing to bid the market aggressively higher.
The end result will be deeper pullbacks, perhaps with a more complex structure.
The magic of Fibonacci numbers to trade pullbacks
There is valuable information in the character and size of the pullbacks in a trend.
A strong trend will tend to generate smaller pullbacks.
The Fibonacci Retracement (Fib. Ret.) is a powerful tool to use when identifying key areas where pullbacks end before resuming the primary trend.
However, since price action is driven by market players, they are not exact science and they have their limitations too.
More importantly, use it along with other tools that you may already have to find areas of confluence.
They key is to add confluence to fibonacci levels, with a price channel, a support, a resistance and so on…
Fibonacci numbers were introduced by Leonardo Pisano Bogollo (1170-1250), an Italian mathematician from Pisa.
He is known to have discovered the numbers, which are a sequence of numbers where each successive number is the sum of the two previous numbers.
Example: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610……
As shown, when you sum a number (n) to its preceding number (n-1), you’ll get the next in sequence (n+1).
For example, when you add 1+1, you get 2. When you add 5+8, you get 13. Or when you add 233+377, you get 610? And so on.
The sequence extends to infinity and contains many unique mathematical properties.
These numbers are based on Liber Abaci, a book on arithmetic by Leonardo of Pisa, known later by his nickname Fibonacci.
Liber Abaci was among the first Western books to describe Hindu–Arabic numbers traditionally described as “Arabic Numerals”.
The Fibonacci numbers are Nature’s numbering system.
They appear everywhere in Nature, from the leaf arrangement in plants, to the pattern of the florets of a flower, the bracts of a pinecone, or the scales of a pineapple.
The Fibonacci numbers are therefore applicable to the growth of every living thing, including a single cell, a grain of wheat, a hive of bees, and even all of mankind.
Of course, that happens to include financial markets, since prices are driven by human beings (and humans are part of natural phenomena).
Fibonacci retracements to trade pullback areas of termination
The ratio used most often is 0.618.
This is found by dividing one Fibonacci number into the next-in-sequence Fibonacci number (Example: Both 55/89 or 377/610 = 0.618).
It is represented by the Greek letter phi (φ), pronounced “fie.”
Its inverse is 1.618.
Phi is the only number that, when added to one, is also equal to its inverse.
Indeed, the inverse of that is commonly known as… the Golden Ratio 1.618.
If we square-root phi or subtract phi from 1, the result is .382, which is another Fibonacci ratio.
Told you, it’s like magic.
These phenomena define how nature evolves and behaves.
Well, other ratios include 0.236, 0.382 and 0.764.
As these Fibonacci (Fib) numbers can be applied in technical analysis, Fib ratios have been used with success by many traders to identify areas where the price would potentially reverse (at the end of the retracements or pullbacks) back into the primary trend.
Without any surprises, the typical Fib ratios that are used include 23.6%, 38.2%, 50%, 61.8%, 76.4% and 100%.
However, 38.2%, 50% and 61.8% are known as the key ratios and have been found to be more useful than the rest.
Hence, many technical traders also associate this with a Fib Ret ratio.
Actually, the 50% Fib Ret is not a Fibonacci number.
Nonetheless, this number is derived from Dow Theory’s assumption that price generally retraces to half its primary price movement so we strongly advise you to keep it on your chart.
Fib Ret ratios are more useful when the price is in a trending market because it is assumed that price is likely to continue in its major trend direction.
Let’s have a look at some examples.
Trade pullbacks successfully using the Golden Pocket
Well, you should now start to visualize the magic of fibonacci.
In the introduction of this post, we told you we were going to share with you a tip we use in our trading on daily basis.
Your job consists simply of adding a discretionary 0.66 fibo on your chart.
Because the 0.61 to 0.66 zone defines what we call the “golden pocket” or “GP”.
The golden pocket is a key area to pinpoint an area where price will more often than not reverse, or at least, stall for a moment.
Yes, it’s a reversal area where price will come and reverse, creating a higher low, or a lower high, right before running strongly in the opposite move.
Combined with the swing pivots technique, you have now a very strong tool to read price action.
And take advantage of the best risk to rewards trading opportunities…
It works on any asset and on any timeframe.
If you think it does not work, simply look at these charts.
To trade pullbacks consistently you can look for confluence zones or levels
The best trades come when there is a confluence of signals from price action and several indicators which all point in the same direction.
Actually, when you have two or more indications that come together at a certain point on your chart, you have a confluence.
For example, a confluence area for price to find support can be the meeting point of:
- Support or resistance
- Price channel
- Fibonacci retracements levels
- Dynamic resistance/support based on moving averages (ie bollinger bands)
The more elements you can find to add accuracy to a price level or area, the more probable is your trade to be a profitable one.
But remember, to buy on pullbacks, markets must be trending.
6 tips to trade pullbacks efficiently
1. Markets must be trending.
The most important condition for this trade is that the market must be trending.
One useful way to approach trend trades is to consider conditions that would contradict this trade, which are the standard preconditions for countertrend trades.
In the absence of any of these (e.g., momentum divergence, overextension on higher time frames), with-trend trades are fully justified.
2. No sharp opposite momentum
Once the main prerequisites of a trending market with no contradictory conditions are satisfied, we turn to the geometry of the pullback pattern itself.
Good pullbacks almost always show reduced activity (smaller ranges for individual bars) and the absence of strong countertrend momentum.
This is why traditional technical analysis suggests that volume should be lighter in pullbacks.
Analysts are zeroing in on the (valid) fact that trading activity should be less on the pullbacks.
In all cases the best pullbacks have reduced activity, which is visible on the lower time frame in:
- Price action
- The lack of strong countertrend momentum on the trading time frame but necessarily on lower volume per se.
3. A winning pullback shows good follow-through
Lastly, it also makes sense to be responsive to developing market structure, even after the trade is initiated.
A pullback may emerge at a spot where the trade was justified.
But developing price action may suggest that the trend is losing integrity.
If this happens, it is not necessary to hold the trade to the original stop-loss level.
To trade pullbacks one needs to say alert and witness strong follow through once the trade has been initiated.
It is also plausible to scratch the trade, exiting for a small win or loss, and to wait for better opportunities if the price structure isn’t following the expected scenario.
A good trading plan will allow flexibility and will encourage the trader to be responsive to developing market conditions.
4. The best entries have strong confluence
The actual entry for this trade is buying against the high timeframe support level near the bottom or selling short against the resistance near the top of the pullback.
There is an important trade management issue to consider: support and resistance levels usually slope in these patterns.
It means that the traders need to stay focused on:
- High timeframe support/resistance levels
- Dynamic/support resistance based on MA or BB for example
One of the advantages of buying against these supports is that, usually, your risk is fairly clearly defined.
It can be difficult to define the risk on a position entered against a sloping support or resistance level.
Having the level itself is not enough; it is also important to have a clear trigger against that level to support the actual entry.
One of our favorite triggers is buying against the support at the bottom of the pullback.
It is always possible to find examples of this entry on historical charts, but it can be considerably more difficult to make this trade in real time.
Stop placement is problematic because the support can drop, washing weak-handed longs out of the market.
But it’s a classical Swing Failure Pattern entry on a low timeframe.
5. The parallel channel fake-out trigger
It is possible to draw a trendline on both sides of price action or simply on the pullback, but, barring that, a parallel trend channel can be used.
The entry trigger is:
- a failure of this trend line or channel,
- followed by an immediate reversal;
The line is penetrated, but prices recover back above the trend line within a few bars.
Conceptually, what has happened is that traders buying into the pullback against the support level have been washed out of the market by the drop below that support.
Note that this will often coincide with a lower timeframe climax, though it’s not necessary.
This entry has the advantage of excellent trade location; some of these will actually be very near the low tick of the pullback.
The only real disadvantage of this entry is that considerable experience may be required to read the market correctly at these spots.
And, even on relatively long timeframes, you have to pay attention because the exhaustion below support will happen on a single bar.
This is a skilled trader’s tool, not a buy-and-forget entry.
6. Avoid trading pullbacks after a climax
It is usually a good idea to avoid trading pullbacks after conditions that could indicate a buying or selling climax.
We have looked at these parabolic expansions and have seen that they frequently cap trends, so it does not make sense to enter with-trend pullbacks after such a move.
Confirmation of the end of the current trend comes with:
- Very strong countertrend momentum
- Break in market structure
Rather than shifting into an immediate change of trend, the market can also consolidate and work off the overextension through a more extended consolidation.
Normal (simple) pullbacks do this, as they give the market time to pause and digest each trend leg.
In the case of a more serious overextension, a larger consolidation is usually required if the trend is going to continue, and these longer consolidations often take the form of complex consolidations.
If you see a condition that would normally eliminate the possibility of a pullback (e.g., a buying or selling climax), a with-trend trade may still be possible following a complex consolidation in that same area.
It is often easier to evaluate the integrity of the trend on the higher time frame, as the trading time frame complex consolidation will usually be a simple consolidation on the higher time frame.
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