Pullbacks or Breakouts? A Short Term Trading Strategy You Can Believe In
When we buy stocks or exchange-traded funds, our goal is to buy them when they are “on sale” or cheap. For us, we take the same attitude toward buying stocks and ETFs as we do when buying anything else: we look for quality merchandise and, when we find it, wait for the merchant to mark that merchandise down. And when that sale sign goes up, we get ready to pounce.
Why don’t more traders trade this way? After all, if the average person sees a great cashmere sweater at one price, and then returns to the store to see the exact same sweater with a price that is 10% or 15% higher, is that person more or less likely to buy it? Most people, I would imagine, would tell themselves “Darn it, I should have bought it when it was cheaper. I’ll wait and see if the price comes back down.”
Not so when it comes to stocks and ETFs. For many traders, when stocks and ETFs are the items on display, the greater the price change to the upside, the more interested they are in buying them. It is as if simply by changing the price tag, that same cashmere sweater has suddenly become intrinsically more valuable.
This is not to put down breakout trading strategies. There are a large variety of ways of making money buying and selling stocks and ETFs. And there is no denying the popularity of the “buy high, sell higher” approach to trading.
(That said, I’ve always found it interesting that many of those who have made the most productive use of breakout trading strategies have been long term trend traders who use breakouts as a way of getting into positions they may hold for weeks or months, not short term traders who hope to be “selling higher” a few days after a stock or ETF makes a new high.)
For traders who have been burned by failed breakouts, our approach to short term trading may be an alternative worth trying. Not only does buying low and selling high have a sort of common sense appeal, but also we have quantified that buying stocks and ETFs after they have pulled back and become oversold actually outperforms the “buy high, sell higher” approach to trading in the short term.
As Larry Connors and Cesar Alvarez note in Short Term Trading Strategies That Work: “Since 1995, had you bought every 10-period low and exited when the market crossed above its 10-period moving average, you would have made 1048.70 S&P points being invested only 28.81% of the time. Plus 73.5% of your trades would have been profitable.”
Now that is high probability trading any short term trader can believe in.
David Penn is Editor in Chief at TradingMarkets.com.