trading-pullback

Trading the financial market is not that difficult if you know what to look for and be disciplined enough to act in a consistent manner whenever you see what you are looking for.

But first things first — you have to know what works in the market so that you can look for it. 

Pullback strategies have proven to be one of the most common profitable ways to trade the financial markets.

Learning how to trade pullbacks is one of the best skills you can acquire as a trader because there will always be pullbacks in the market as long as there is a trend. 

In this post, we will explain the different ways you can trade pullbacks, but first, we will explain what a pullback is and why pullback strategies work so well.

What is a pullback?

Before we delve into the subject matter, let’s make one thing very clear — in a ranging market, you don’t talk about pullbacks, instead you deal with up and down price swings.

In other words, when you are talking about pullbacks, you’re dealing with a trending market.

Now, a pullback, also known as a retracement, corrective wave, or, simply, a correction, is a counter-trend price movement.

That is, a temporary price movement that is opposite to the direction of the main trend.

So, if the direction of the trend is up, a pullback moves downward, and if the trend direction is downward, a pullback moves upward.

Here is the thing : the price does not move in a straight line, even when it is trending. It moves in a zigzag fashion, consisting of up and down waves.

Depending on the direction of the trend, these can either be impulse waves or corrective waves (pullbacks).

While the impulse waves move in the direction of the trend and have stronger momentum, pullbacks are weaker and move against the trend direction.

Pullbacks arise as a result of traders, especially those who trade the individual price swings, taking the profits they made from the preceding impulse wave.

In addition, there are also the effects of contrarian traders who try to counter every price advancements.

They tend to drive the price against the trend, but on most occasions, the move is only a temporary one. However, on some occasions, a pullback may be the beginning of a trend reversal.

Why do pullback strategies work?

Traders who make use of pullback strategies don’t aim to trade the pullback moves — that would mean going against the trend — rather, they trade the reversal of pullbacks to the trend direction.

So, the correct name is pullback reversal strategies, and they work on most occasions. 

Pullback strategies work quite well because the trades are made in the direction of the underlying trend.

Traders try to anticipate when a pullback will end so that they can join the next impulse wave because they know that pullbacks are temporary price moves caused mainly by profit taking and a few contrarian orders, which do not carry sustained momentum.

With pullbacks, you are able to enter the market at an area of value. In other words, you’re buying low in an uptrend and selling high in a downtrend.

Moreover, you are likely to enter the market at the very beginning of an impulse wave — unlike in breakouts where you enter an already extended price wave.

Apart from that, the strategy lowers entry point risk since the trades are made at price reversal levels, such as support or resistance levels depending on the trend direction — support levels in an uptrend and resistance levels in a downtrend.

Those key market levels usually have a high volume of limit orders lying around them, which when triggered can push the price back in the trend direction. 

Furthermore, you can place your stop loss order on the other side of the key price level, so the strategy allows you to have a tighter stop loss. This can improve the reward/risk ratio of the trades.

Of course, pullback reversal strategies are not the trading Holy Grail. There are some demerits to trading them, such as:

  • It’s difficult to know when a pullback has ended
  • Sometimes, a pullback may herald a full trend reversal
  • If the pullback does not reach the key level you are watching, you may miss the trade entirely
  • Tools for trading pullback strategies

    As with any trading strategy, to trade pullback reversal well, you must have ways of identifying tradable setups.

    That is, you must have clearly defined criteria for picking trades with a high odd of success. Three factors are required for trading pullback reversal strategies :

  • A trending market
  • Price reversal levels
  • Trade triggers (signals)
  • The trend

    You can only trade pullback strategies in a market that has an established trend, either in the upward direction or in the downward direction.

    A trending market is one that is predominantly moving in a particular direction, even though, from time to time, the price swings in the opposite direction, which creates the opportunity you want to trade.

    Your aim is to trade in the direction of the trend, so you must be able to identify the direction of the trend.

    You can use the successive price swings to identify the trend direction — higher swing highs and swing lows indicate an uptrend, while lower swing lows and swing highs indicate a downtrend. 

    Alternatively, you may need to use a trend line to delineate the trend direction or make use of a long-period moving average whose slope can tell you the direction of the main trend.

    Once you have identified the trend direction, you need to know where to look for trades in the trend direction.

    Price reversal levels

    Price reversal levels are key market areas where the price is likely to reverse and start a new swing in the opposite direction.

    The reversal of an impulse wave is the beginning of a pullback wave, while the reversal of a pullback wave leads to a new impulse swing in the trend direction.

    Both impulse swings and pullbacks reverse at key price levels, but the particular level where each reverses depends on the direction of the trend.

    In an uptrend, impulse swings reverse at resistance areas, while pullback swings reverse at support areas.

    For a downtrend, impulse waves reverse at support areas, while pullback swings (rallies) reverse at resistance areas.

    Since we intend to trade in the trend direction and enter the market at the beginning of an impulse wave, we should only be interested in where a pullback might reverse. That is where to look for trade setups.

    So, if we are in an up-trending market, we should be looking for trade setups at the support areas, indicated by previous swing highs and lows, ascending trend lines, long-period moving averages, Fibonacci retracement levels, and important round numbers — all lying below the current price level.

    In a down-trending market, the focus should be on resistance areas, which, of course, lie above the current price level, and they can be estimated with a descending trend line attached across previous price swing highs, a long-period moving average, big round numbers, pivot levels, and previous swing highs or lows.

    Trade triggers

    Now that we know the direction to trade and where to look for trade setups, we need to have the third factor — a trade signal — which tells us when to enter a trade.

    A trade signal or trigger is a clearly defined setup that, when it occurs at the right price level in the right direction, is an indication to enter a trade immediately.

    There are several trading tools you can use as a trade trigger, but the most common and effective ones for trading pullback reversal strategies are these :

  • Reversal candlestick patterns
  • Oscillators signals
  • Counter-trend line breakouts
  • Reversal candlestick patterns

    These are candlestick patterns that signal a potential price reversal. They show when a price swing is losing momentum and is about to turn in the other direction.

    When they occur at a key price level during a pullback, they can be powerful reversal signals. 

    They are classified into bullish reversal patterns (such as bullish pin bar, bullish engulfing bar, bullish inside bar, and morning star patterns) and bearish reversal patterns, such as bearish pin bars, bearish engulfing, bearish inside bar, and the evening star pattern. 

    A bullish reversal pattern occurring at the end of a pullback in an uptrend may be an indication to go long.

    Conversely, a bearish reversal pattern at the end of a pullback in a downtrend may be a signal to short.

    Oscillator signals

    Oscillators are unique indicators, which can show when the price is possibly overbought or oversold.

    While the overbought or oversold regions are pretty useless for an impulse swing in the trend direction, they can be useful in timing when a pullback is losing momentum so that you can take a position for the next impulse swing.

    Some of the oscillator indicators you can use include stochastic, RSI, CCI, William’s %R, and stochastic-RSI.

    In an uptrend, an oversold signal (the indicator climbing out of the oversold region) may indicate a potential reversal of the selloff.

    An overbought signal (the indicator climbing down from the overbought region) in a downtrend may indicate a possible reversal of the price rally.

    Another oscillator signal, which is even more potent than the overbought/oversold region, is the divergence between the indicator line and the price swing.

    Depending on the price structure, a divergence can be bullish or bearish. A bullish divergence in an uptrend may signal the end of a pullback, while a bearish divergence in a downtrend may indicate the end of a price rally.

    There are two types of divergence: classical divergence and hidden divergence. You can learn more about them from our post on divergence strategies.

    Counter-trend line breakouts

    This is a very simple way to estimate when a pullback is over and a new impulse wave is emerging.

    It only requires you to put a trend line (called a counter-trend line because it’s against the trend direction) on the mini-swings of the pullback wave — a price close beyond the counter-trend line may be an indication that a new impulse wave is emerging.

    In an uptrend, the pullback moves downward, so you place the counter-trend line along the highs of the candlesticks in the pullback wave.

    A breakout above the counter-trend line may be an indication to go long, as a new impulse wave is starting.

    In a downtrend, the pullback moves upward, so you attach your counter-trend line along the lows of the pullback swing.

    When the price breaks below the counter-trend line, it may be the beginning of a new impulse swing down. 

    Strategies for trading pullbacks

    Great, you have all the tools you need to trade pullback strategies. But how do you put them all together and formulate a profitable trading strategy? Now, we will show you how to trade pullbacks using some of the different tools that show key value areas in the market. In the end, we will talk about using a confluence of many tools. 

    A pullback to a support or resistance level

    We suppose you already know what support and resistance levels are — a support level is an area below the current price level where the price may end a downward swing and head upwards, while a resistance level is an area above the current price level where the price may stop an upward advancement and turn downward.

    So, in an uptrend, you look for tradable opportunities at support levels, while in a downtrend, you try to trade from resistance levels. 

    Here is what you do when you identify an up-trending market:

    -Mark the important support levels — previous swing highs and lows — and take special note of recent resistance levels the price broke as it climbed upward, which have now become support levels

    -Look for your trade trigger when the price pulls back to the support level of interest. Your trade trigger can be a bullish reversal candlestick pattern, an oscillator oversold signal or bullish divergence, or an upward breakout of the counter-trend line.

    -Place your stop loss some pips below the pullback’s low or a few pips below the preceding swing low

    -Trail your profit or put a profit target at the next resistance level or the 100% Fibonacci expansion level.

    This is a chart of the Dow 30 Index, showing an uptrend. Notice the inside bar pattern that formed at the support level.

    pullback-trading-strategies

    If you are trading a down-trending market, here is what to do :

    -Mark the previous swing highs and lows lying above the price (resistance levels) and take special note of recent support level the price broke as it climbed lower, which has now become a resistance level

    -Watch out for your trade trigger when the price rallies to the resistance level. A trade trigger, here, can be a bearish reversal candlestick pattern, an oscillator overbought signal or bearish divergence, or a downward breakout of the counter-trend line

    -Place your stop loss some pips above the pullback’s high or a few pips above the preceding swing high

    -Trail your profit or put a profit target at the next support level or the 100% Fibonacci expansion level

    In this S&P 500 Index chart, the market is in a downtrend. A bearish engulfing and an inside bar pattern formed at the resistance level.

    pullback-trading-trading-strategies

    A pullback to a trend line

    Trend lines are another tool you can use to trade pullback reversals. They are diagonal lines attached across swing lows or highs to delineate the direction of the trend.

    But in addition to showing trend direction, they can also serve as ascending support levels in an uptrend and descending resistance levels in a downtrend.

    In an up-trending market, here is how to spot good trades with an uptrend line :

    -Attach your trend line across the first two major swing lows. If the price is speeding away from this first trend line, you can add another trend line to match the steeper trend

    -Whenever the price pulls back to your trend line, look for your trade trigger which can be a bullish reversal candlestick pattern, an oscillator oversold signal or bullish divergence, or an upward breakout of the counter-trend line

    -Place your stop loss some pips below the pullback’s low or a few pips below the preceding swing low

    -You can trail your profit or put a profit target at the next resistance level or the 100% Fibonacci expansion level, or place another trend line across the swing highs, forming a channel, to estimate your profit target

    The US500 Index chart below shows an uptrend. You can see that a pullback to the trend line ended with an inside bar, which is an indication to go long. Notice the oversold signal in stochastic and counter-trend line (blue line) breakout, which can also be your trade trigger.

    pullback-trading

    Here is how to use a downtrend line to trade a bear market :

    -Place your main downtrend line across the first two major swing highs. If the price is dropping faster, you can add another trend line to reflect the steeper trend

    -Anytime the price pulls back to your trend line, check for your trade trigger — a bearish reversal candlestick pattern, an oscillator overbought signal or bearish divergence, or a downward breakout of the counter-trend line

    -Put your stop loss some pips above the pullback’s high or a few pips above the preceding swing high

    -You may trail your profit or put a profit target at the next support level, 100% Fibonacci expansion level, or place another trend line across the swing lows, forming a channel, to estimate your profit target.

    This Tesla chart shows a downtrend. The price pulled back several times to the downtrend line and on two occasions, it formed bearish candlestick patterns: pin bar and inside bar. Notice the hidden bearish divergence on both occasions. 

    pullback-trading-strategies

    A pullback to a long-period moving average 

    Apart from helping you identify the direction of the trend, long-period moving averages — 100 0r 200 SMA, SMMA, EPA, and LWMA — can serve as dynamic support or resistance levels, depending on the direction of the trend.

    In an uptrend, they lie below the price, so they serve as dynamic support levels, while they stay above the price in a downtrend, serving as dynamic resistance levels.

    To use the moving average in an uptrend, this is what you do :

    -Attach a long-period moving average to your chart and note its upward slope and the position of the price above the moving average.

    -Wait for the price to pull back to the moving average line and look for a bullish trade trigger — a bullish reversal candlestick pattern, an oscillator oversold signal or bullish divergence, or an upward breakout of the counter-trend line

    -Put your stop loss some pips below the pullback’s low or a few pips below the preceding swing low, which is safer

    -Use a trailing stop if you want to ride the trend, otherwise, put a profit target at the next resistance level or the 100% Fibonacci expansion level

    Here is an uptrend in a gold chart. See how the price reversed when it dropped to the 200-period moving average and formed a bullish pin bar.

    pullback-to-moving-average

    In a down-trending market, here is what you do :

    -Attach a long-period moving average to your chart and note how it is sloping downwards, with the price staying below

    -Wait for the price to rally to the moving average line and check for a bearish trade trigger — a bearish reversal candlestick pattern, an oscillator overbought signal or bearish divergence, or a downward breakout of the counter-trend line

    -Place your stop loss some pips above the pullback’s high or a few pips above the preceding swing high, which may be safer

    -You can use a trailing stop to ride the trend if you want, or you may put a profit target at the next support level, 100% Fibonacci expansion level

    The NZDUSD chart below shows a downtrend (downward-sloping, 200-period EMA). Notice the bearish pin bar that was rejected above the 200-period EMA and how it coincided with the oversold signal in stochastic

    pullback-with-schocastics

    A pullback to a Fibonacci retracement level

    The Fibonacci retracement levels show the percentage of the preceding impulse swing to which the pullback can get to before reversing.

    The levels act as potential support or resistance levels, depending on the direction of the trend, but the most important levels are 38.2%, 50%, and 61.8% levels.

    Here is how to use the Fib retracement level in an up-trending market :

    -When a new pullback starts, attach the Fib retracement tool to the preceding impulse wave, from the swing low to the swing high

    -Wait for the pullback to reach the 50% Fib level and then look for a bullish trade signal — a bullish reversal candlestick pattern, an oscillator oversold signal or bullish divergence, or an upward breakout of the counter-trend line attached on the pullback

    -You can place your stop loss some pips below the next or next two Fibonacci levels

    -If you want to ride the trend, trail your profit, otherwise, put a profit target at the next resistance level or the 100% Fibonacci expansion level

    The EURUSD below shows an emerging uptrend. Notice that the price pulled back to the 61.8% level and formed a bullish pin bar. After much back and forth movement, the price climbed. There was a bullish divergence in the stochastic too

    pullback-trading-strategies

    In a downtrend, here is how you can use the tool to find a shorting opportunity :

    -When a new pullback starts, attach the Fib retracement tool to the preceding impulse wave, from the swing high to the swing low

    -When the pullback reaches the 50% Fib level, look for a bearish trade signal — a bearish reversal candlestick pattern, an oscillator oversold signal or bullish divergence, or an upward breakout of the counter-trend line attached to the pullback — and go short

    -Place your stop loss some pips above the next or next two Fibonacci levels

    -If you want to ride the trend, trail your profit, otherwise, put a profit target at the next resistance level or the 100% Fibonacci expansion level

    The Brent Crude Oil chart below shows a downtrend. A bearish engulfing pattern occurred when the price retraced to the 50% level. Notice the bearish divergence and the counter-trendline breakout. You could enter the trade with any of those three triggers.

    pullback-with-fibonacci

    A confluence of many tools

    While one of the tools that indicate key price levels may be enough, a trade has a higher probability of success when there is a confluence of those tools.

    For example, if, in an uptrend, a bullish trade trigger appears when the price pulls back to a junction of an uptrend line and support level, you have a high probability buy setup, as you can see in the S&P 500 Index chart below.

    pullback-trading-strategies

    Similarly, if, in a downtrend, a bearish trade trigger occurs at the junction of a trend line or moving average and a resistance level or a Fib level, you have a high probability sell setup. See that Tesla chart 

    when a Fibonacci retracement was added to the first swing. The bearish pin bar was at a confluence of the trend line and the 61.8% Fib level.

    pullback-with-fibonacci

    However, you don’t need to wait to have a confluence of many factors before you can enter a trade — that would mean trading less frequently and missing many good trades. All you need to have a quality pullback trade setup is the trend, a pullback to one of those tools, and a trade trigger.

    Final words 

    Pullback trading strategies are among the most commonly used trading strategies because they work very well and also offer a good reward/risk profile. You need not use all the tools listed here at once — with one or two tools to identify the key price level, a good trade trigger, and the trend, you are good to go.

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