How To Use TM’s Indicators: The Pullbacks From High/Low Lists
“The trend is
your friend” is an old Wall Street adage. However, this doesn’t mean that
you should blindly buy (or sell short) a market just because it’s in a trend.
You’re much better off waiting for a normal correction to occur before
attempting to enter. Below we will look at how to trade trending markets after
they have pulled back.
Pullback Defined
Before a pullback can occur, the
market should be in a trend and must make a new high. This new high should be at
least a 1-month high (20-22 trading days) and, preferably, two months (40-45
trading days) or more. The stock should then have an orderly sell off of, on
average, three-to-seven days. This is known as the width of the pullback. The
amount a stock corrects is known as the depth. Essentially, pullbacks should be
deep enough to flush out the weak hands but not deep enough to be categorized as
a new downtrend.
Also, corrections tend to be deeper in
volatile markets that attract fast money, requiring a looser pullback
definition. For example, a deep correction in a hot technology stock is more
acceptable than one in a consumer cyclical issue. Therefore, less volatile
stocks may only correct (say 5%-10%) before resuming their uptrends, while
more volatile stocks may correct 15-20% or more. Keep in mind that the above are
general rules of thumb for defining a pullback. Each market should
be evaluated on a case-by-case basis.
Trading Pullbacks
As mentioned above, the market must
first be in a strong trend (a) before a
pullback can occur. Once the pullback occurs (b),
look to enter if, and only if, the trend begins to re-assert itself (c).
Once filled, place a protective stop below the low of the setup (d),
just in case the correction has not completed itself.
No Tickee, No
Tradee
When you begin to analyze a pullback,
you have no way of knowing if this is just a normal (and healthy) correction or
the start of something bigger. One of the simplest, yet possibly most important
aspects of about trading pullbacks is to wait for an entry.Trading pullbacks is not
about fading the market. As mentioned above, the idea is to enter if, and
only if, the trend begins to re-assert itself. By waiting for this
entry, you can often avoid markets that have topped out. The figure below
illustrates a market that failed in its pullback, but did not offer an entry.
Real World
Looking below to Symantec, we notice
that the stock is in a strong uptrend (a)
and then begins to pull back (b). An entry
is triggered above the prior day’s high as the trend resumes
(c). A protective stop is then placed below the low of the setup (d),
just in case the correction is not complete.
Here’s an example on the short side in
the BroadBand Holders. Notice that there were in a strong downtrend
(a) and then began to pullback (b).
An entry is triggered below the prior day’s lows as the trend resumes
(c). A protective stop is then placed below the high of the setup (d),
just in case the correction is not complete.
Identifying Pullback
Candidates
Trading Markets publishes a list of
the 30 strongest stocks that are in pullbacks nightly it its Pullbacks
Off Highs List. For short candidates, Trading Markets also publishes the 20
weakest stocks that have pulled back in its Pullbacks
Off Lows List. For those wishing to get a head start, you might consider
monitoring the various momentum such as the Proprietary
Momentum List, New
60-day Highs on Double-Volume List, Momentum
10 Technology List, etc. Many times, stocks will show up on these lists long
before they make it to the pullback list.
Choosing The Best
Setups
Not all setups are created equal.
Ideally, a stock should be in a strong trend, it should be persistent (i.e.
follow through from one day to the next) and it should be in one of the
strongest sectors (for longs). For more on picking the best stocks, see the
article on stock
selection under Traders Lessons.
Also, there’s no substitute for
experience. If you are fairly new to trading, look at the pullback list(s) that
are generated nightly. Study these stocks over the next few days. Question which
one worked. Question which one didn’t. Ask yourself: What were the market
dynamics? What were the sector dynamics? What made one setup better than others?
Money Management
And Position Management
No strategy is complete without a risk
control plan. Although placing your order above the market helps ensure the
market is moving (at least temporarily) in your direction, it in no way
guarantees a pullback is complete and the market will resume its up trend in
full force. As a result, it is necessary to protect yourself with stop order.
As mentioned above, the most logical
place for a protective stop is below the lowest bar of the pullback. If the move
turns out to be a much deeper correction, or the beginning of a new downtrend,
you will (hopefully) be stopped out with only a small loss. Professional traders
are willing to take several “stabs” at a market, keeping risks small,
in the hope of capturing a larger move.
Money management is crucial to any
pattern or style of trading. However, it’s beyond the scope of this article to
cover it in detail. The good news is, there are plenty in depth articles on the
topic under the Money
Management section of Traders’ Lessons.
Summary
In summary, pullbacks are fairly
simple yet often effective technique for entering markets that are in strong
trends. The idea is to wait for the market to have a normal, and often healthy,
correction, then look to enter that market if, and only if, the trend
begins to re-assert itself. Protective stops are used below the low of the
formation just in case the correction is not over. Trading Markets publishes a
list of potential pullbacks nightly along with momentum lists of stocks that
could be the next pullback candidates.
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