Pullback Trading: 5 Things to Look for Before You Place a Trade

Imagine:

You’re waiting for a pullback towards support before you get long.

Somehow, the market knows what you’re trying to do and it doesn’t re-test the level you’re looking at.

Instead, the market continues to move higher without you—argh!

Sounds familiar?

Then you’re not alone.

The good news is, there’s a fix for it if you know what to look for in a pullback trade.

So read on…

#1: Trade in the direction of the trend

The first step to pullback trading is to identify a trend (that’s relevant to your timeframe), and then trade in the direction of it.

For example, if you’re trading the daily timeframe, then you must have a trend on the daily timeframe.

Here’s what I mean:

Or if you’re trading on the 1-hour timeframe, then you must have a trend on the hourly timeframe

An example:

Remember:

For pullback trading to work, the market must be trending (which means you can ignore range market condition).

#2: Classify the type of trend

Here’s the deal:

Not all trends are created equal.

Some have shallow pullbacks whereas some have deep pullbacks.

So here are the 3 types of trends every trader must know:

• Strong trend: The price respects the 20MA and remains above it
• Healthy trend: The price respects the 50MA and remains above it
• Weak trend: The price respects the 200MA and remains above it

You’re probably wondering:

“What’s the purpose of knowing the different types of trends?”

That’s because it helps you to identify the area of value on the charts, so you know where exactly to enter your pullback trade.

I’ll explain more in the next section, read on…

#3: Identify your area of value

In an uptrend, the area of value refers to the location on your chart where buying pressure could step in and push the price higher.

So let’s dive in…

In a strong uptrend, the area of value is at the 20MA.

Here’s an example…

In a healthy trend, the area of value can be at the 50MA (or at previous resistance turned support).

An example…

Finally, in a weak trend, the area of value is at the 200MA (or at support).

Here’s what I mean…

Pro Tip:

We’re dealing with an area on your chart, not a specific price level.

So, be prepared that the market could exceed your area of value before reversing higher.

#4: Entry trigger to time your pullback trade

An entry trigger is a “pattern” that gets you into a trade after all your conditions are met.

(In this case, our conditions are 1) trading in the direction of the trend 2) classifying the type of trend 3) identifying the area of value.)

There’s no need to complicate things here because an entry trigger could be as simple as buying on a pullback, or on a breakout.
I’ll explain…

Strong trend

As you know, a strong trending market has a shallow pullback and remains above the 20MA (for an uptrend).

This means buying on a pullback can be difficult because the pullback is usually short-lived before the trend resumes higher.

So, an easier approach is to buy a breakout of the swing high.

Here’s an example…

Healthy trend

In a healthy trend, the pullback is healthy and it could re-test the 50MA or previous resistance turned support—so these are areas to look for buying opportunities.

Next, you can look for a bullish reversal candlestick pattern (like Hammer, Bullish Engulfing Pattern, etc.) as an entry trigger to get long

Pro Tip:

You can also buy a breakout in a healthy trend, but your stop loss is wider as it needs to go below the 50MA or, the previous swing low. More on this later…

Weak trend

In a weak trend, the pullback is deep and it could re-test the 200MA or, support area.

Next, you can look for a bullish reversal candlestick pattern (like Hammer, Bullish Engulfing Pattern, etc.) as an entry trigger to get long.

Here’s an example… 

Onward…

#5: Exits to protect your account and maximize your profits

Now, there are 2 types of exits to consider:

1. Exit when you’re wrong
2. Exit when you’re right

Let me explain…

Exit when you’re wrong

After you enter a trade, there’s a possibility the market could move against you.

So, at which point on the chart will you get out of the losing trade (otherwise known as your stop loss)?

Well, you want to exit the trade when your trading setup is invalidated.

For example:

In a strong trending market, the area of value is around the 20MA.

So, if the price breaks below the 20MA, then the area of value is breached and you should get out of the trade.

Here’s what I mean…

Here’s another one…

In a healthy trend, the area of value could be at previous resistance turned support.

This means if the price breaks below support, then the area of value is breached and it’s time to get out of the trade.

Here’s what I mean…

Next…

Exit when you’re right

Now what if the market moves in your favour, how will you exit your winner?

Here are a few general guidelines:

Strong trend: In this market condition, it’s ideal to ride the trend because the pullbacks are shallow which makes it easy to hold onto your winner.

You can trail your stop loss using the 20MA and exit the trade only when the price closes below it.

Healthy trend: In this market condition, you can capture a swing by exiting your trade before the swing high.

Or else, you can ride the trend using the 50MA, but bear in mind the pullbacks are deeper which requires you to withstand more “pain”.

Weak trend: In this market condition, you want to avoid riding a trend because the pullbacks are deeper and will likely stop you out of your trade.

Instead, look to capture a swing at resistance or the previous swing high.

If you want to learn more about swing trading and riding trends, then check these out…

The NO BS Guide to Swing Trading

5 Powerful Trading Stop Loss Techniques That Work

Bonus #1: How to identify high probability pullback trades (for stocks)

When it comes to stock trading, it’s possible to have hundreds of stocks forming a pullback trading setup at the same time.

So the question is:

How do you know which stocks to buy and which to avoid?

Well, the secret is to focus on stocks which have increased the most in price over the last 12 months.

Why?

Because these are stocks likely to outperform the market (and it’s been proven in theory as well according to the paper Returns to Buying Winners and Selling Losers by Jegadeesh and Titman).

So, how do you apply this to your trading?

1. Rank stocks according to their rate of change (ROC) over the last 50-weeks—from the highest to the lowest
2. Look for a pullback trading setup on stocks with the highest ROC value. If there isn’t, then move to the next stock (with a lower ROC value)
3. The top 5 stocks with a valid pullback trading setup are the ones to focus on

Pro Tip:

You can use a platform like Thinkorswim to help you rank the stocks, and it’s free.

Bonus #2: Multiple plans of attack

Most of the time, the market will not behave the way we want it to be.

For example:

You’re waiting for the price to test support before you look for an entry trigger to go long.

But somehow, the market knows what you’re trying to do. So, it doesn’t test support and continues to move higher, without you.

Sounds familiar?

That’s why as a professional trader, you must have multiple plans of attack.

So, even if the market doesn’t behave in the manner you’d like it to, you’ll still have other setups to capture opportunities in the market.

Here’s an example…

In the chart below, TATA has broken out of resistance. So, one possible setup is to wait for the price to re-test previous resistance that could act as support, around the 358 area.

However, the market knows what you’re thinking and the price doesn’t re-test support. Instead, it consolidates and forms a buildup.

If you’re a one-trick pony, then you’ll remain on the sidelines as the market breaks out higher.

But, if you have multiple plans of attack, then you could also look to buy the breakout of the buildup.

Here’s what I mean:

Make sense?

Conclusion

So here are the things to look for in pullback trading:

1. Trade pullbacks in the direction of the trend (not against it)
2. Classify the type of trend: strong, healthy, or weak
3. Identify the area of value for the respective type of trend
4. Look for a valid entry trigger to get you into a trade
5. Know when to exit when you’re right or wrong

Now over to you…

What do you look for in a pullback trade?

Leave a comment below and share your thoughts with me.