A Better Way To Look At Pullbacks

  • June 30, 2006
  • Eddie Kwong

Many short-term traders like to enter strong trends by waiting for pullbacks
to occur. But how do you defined a pullback? Is it a chart pattern that you
“eyeball” using subjective judgment? Or can pullbacks be quantified?

In today’s
Chart of the Day, we’ll look at research which shows how pullbacks can indeed be
quantified. The way to quantify a pullback is to look at it in terms of how
“stretched” it is. The more stretched something is, the more likely it is to snap back
to it’s normal shape — and that is something you can quantify.

Let’s look at a simple example that is based upon “The Windows Strategy”
published by the Connors Research Group. In the following chart, we’re looking
at The Stanley Works (SWK) which is strongly trending down based on the ADX
indicator1 (see the end of these article for a explanation of ADX). The downtrend
is SWK’s current “normal” behavior. If SWK makes an extreme short-term
move UP, our research on similar situations in many thousands of stocks over a
decade tells us to look for SWK to quickly revert back its norm — which is to
go DOWN. Let’s look at this situation close-up.

  1. The 14-period -DI is above 30 which means that the trend is down.

  2. Over an entire day on June 2, SWK trades above it’s 4-day simple
    moving average (SMA) which is a high degree of stretch. This creates what is called a “Windows” setup.

  3. SWK trades under its June 2 low which triggers a sell signal.

  4. Four days later, SWK has lost 8% of its value.

In this chart, we’ve given you an idea of how pullbacks can be quantified
using “The Windows Strategy.” In effect, it quantifies trend using ADX and it
quantifies stretch using the 4-day simple moving average. In the days to come
we’ll show you more of these examples on both the long and short side. I’ve
enjoyed showing you this Chart of the Day, please feel free to email me at
eddiek@tradingmarkets.com if you
have any questions or comments.

Best regards,

Eddie Kwong

1Definition of ADX

ADX is a indicator that measures the strength of a trend, but not
direction. ADX also includes two other lines that are plotted called +DI and
-DI. The stronger the uptrend, the higher +DI is. The stronger the downtrend
is the higher -DI is. ADX is commonly available and can be found on most
charting platforms.