How to Trade Pullbacks – Part 3: Finding Pullback Trades

Senior Researcher for Connors Research. Mr. Radtke graduated magna cum laude from Michigan State University with a degree in computer science. He has 25 years of software development experience in companies large and small, including Hewlett-Packard and Bell Northern Research.

Mr. Radtke has been actively trading stocks, ETFs, and options since 2008. Over the past several years he has become increasingly involved with the Connors Group family of companies, first as a student, then as a member of Chairman’s Club, and finally as a consultant, researcher, and author.

In part 2 of this article series we provided a high-level overview of the ConnorsRSI indicator. Now we’ll describe the entry rules for a specific variation of the ConnorsRSI Pullback Strategy:

1. The stock price must be above $5 per share.
2. The stock’s average daily volume over the past 21 days (one trading month) must be at least 250,000 shares per day.
3. The stock’s 10-day Average Directional Index (ADX) must be above 30.
4. Today the stock’s lowest price must be at least 2% below the previous day’s close.
5. Today’s close must be in the bottom 25% of the day’s range.
6. The ConnorsRSI value of the stock must be below 5.
7. If the above rules are met today, buy the stock tomorrow on a further intraday limit 10% below today’s closing price.

Let’s look at each rule in a little more depth, and explain why it’s included in the strategy.

Click here to learn how to apply the new ConnorsRSI indicator to Leveraged ETFs in our latest strategy guidebook – Trading Leveraged ETFs with ConnorsRSI.

Rule 1 helps us steer clear of “penny stocks” and other highly volatile, unpredictable companies. Though price is never a guarantee, we have found that $5/share is a good price floor for selecting more stable stocks.

Rule 2 assures that we’re in highly liquid stocks which can be readily bought and sold, with tight bid/ask spreads.

Rule 3 confirms the strength of the recent trend. ADX is non-directional, so it will quantify a trend’s strength regardless of whether it is up or down. However, the next three rules will establish the fact that the stock is currently in a down trend.

Rule 4 identifies a basic pullback: a significant sell-off, measured as a percentage of the previous closing price. Since this rule uses the low price for the day rather than the closing price, we don’t yet know what today’s overall price action looks like, but we do know that the stock faltered in a meaningful way.

Rule 5 gives us more visibility into today’s price action. Closing range is calculated as:

            Closing Range = (Close – Low) / (High – Low)

For example, if today’s Low price was $12.00, the High price was $12.50, and the Closing price was $12.05, then the closing range would be:

            Closing Range = (12.05 – 12.00) / (12.50 – 12.00) = .05 / .50 = .10 = 10%

While Rule 4 tells us that the stock stumbled, Rule 5 lets us know that it did not recover significantly before the end of the trading day, which in turn is a good indicator that the price is likely to fall further tomorrow.

Rule 6 is the key to determining the quality of the pullback. Our research has shown that the lower the ConnorsRSI value is, the larger the bounce is likely to be when the stock recovers.

Rule 7 allows us to enter the trade at an optimal price. We’re taking an already oversold stock as measured by ConnorsRSI, and then waiting for it to become even more oversold on an intraday basis. Because the intraday price drop is occurring for a second consecutive day, it’s often accompanied by a great deal of fear. Money managers get especially nervous and often tell their head traders to “just get me out” after they have made the decision to sell. This panic helps create the opportunity.

Note that the full ConnorsRSI Pullback Strategy includes many variations of the entry and exit rules which can be customized to complement your overall trading plan. The specific variation defined above represents a good middle ground that has historically generated plenty of trades (over 1000 since January 1, 2001), produced a great average gain per trade (over 11%), and had a win rate of nearly 80%.

In Part 4 of this series, we’ll talk about how to exit the Pullback trades.

Click here to read How to Trade Pullbacks – Part 1

Click here to read How to Trade Pullbacks – Part 2

Click here to read How to Trade Pullbacks – Part 4

Click here to read How to Trade Pullbacks – Part 5