What is Pullback in Trading – Its Types and How to Spot Them?
If an asset that has been on an uptrend for a long time experiences a temporary drop, it is known as a pullback. These are very short-term drops to the tune of 5-10%. Pullbacks are common phenomena in a bull market.
Wondering what is a stock market pullback, what causes it, and when is a stock decline a matter of concern? This article will help to address these questions and other doubts regarding pullbacks.
What is a Pullback?
Pullback, also known as price correction, is characterised by a temporary pause or moderate drop in a stock commodities’ pricing chart from the recent highs in an ongoing trend. The price movement or drop is for a short duration of time lasting only for a few sessions.
Following the drop, the uptrend resumes. This provides traders an entry point to hold positions when other technical indicators remain bullish.
How do Pullbacks Work?
T Pullback trading is a commonly used day-trading strategy that begins with an uptrend. Investors look for a stock that has been consistently increasing in price. The likelihood of the established trend continuing is higher if the asset has been on an uptrend for a long time.
Once the stock is identified, investors determine an entry point. This entry point is the pullback stage. Often, investors wait for the stock price to decline by a predetermined percentage, benefit from the discount and help take the price trend higher.
The profitability of the exercise will depend on whether the decline is a temporary pullback, a longer correction or the beginning of a downtrend. Lower trading volumes are among common indicators of a pullback.
If the declines are accompanied by higher trading volumes, it could be a reversal instead of a pullback. A reversal is a longer-term decline caused due to changes in fundamentals instead of temporary demand and supply fluctuations.
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Types of Stock Market Pullback
There are three major types of stock market pullbacks. They are:
- Pullbacks as a Part of a Bull Market: These are regarded as normal pullbacks that often accompany stock market rallies.
- Market Corrections: A stock market crash by about 10% from its highest point is termed a market correction.
- Bear Market: A stock market decline of over 20% from its highest point characterises a bear market.
5 Causes of a Market Pullback
A market pullback may happen for several reasons. Some of them are below:
- Investors are Booking Profits: When the price of a stock or an index sees a steep rise, some investors book profits and exit. This may lead to a temporary drop in prices.
- Poor Earnings for Important Companies: Sometimes when big and important companies publish poor quarterly results, it can lead investors to expect weak earnings growth and thus they sell their shares, leading to a drop in demand and thus price.
- Political Climate: Political events have the potential to cause major pullbacks. For instance, the election of an unpopular leader or bills that affect the consumers can lead to such situations.
- Changes in monetary policies: Changes by a central bank like the federal reserve can increase the possibility of a pullback.
- Technical reasons: Pullbacks may also be caused when a stock market index reaches a key technical level.
How to Spot Pullback Securities?
Spotting pullback stocks at the right time can help to benefit from uptrends by entering at greatly discounted prices.
Identifying stocks that are experiencing a pullback is simpler than it is perceived to be. The first step is to observe the overall price movements of major market indices. If the indices are following a downward trend, the possibility of specific stocks following a downward trend is also higher.
Many traders also use screeners to assess the performance of stocks. The resultant analysis from these screeners is used to identify stocks that are in a pullback. Before attempting to spot pullback stocks, it is important to identify whether it is a pullback or a reversal. Here are some ways to figure that out:
1. Stock Volumes
A price pullback is likely to be accompanied by a drop in trading volume. However, if the volume increases, it can be an indicator that the prices will continue to drop.
2. News
Investors must keep an eye on the company’s performance. If it is making losses or reporting poor results, it isn’t a pullback. Some real-world events also cause the prices to fall and whether the prices will bounce back will depend on the magnitude of the event.
3. Analysis
Traders must focus on the happenings of the last trading day. This will help to assess the reason behind the pullback. So, while a stock price may seem fascinating, a proper analysis will show if there is a risk of a continued fall. Thus, traders ensure an uptrend before making a move or start trading only above the high of the last trading day.
Different Ways to Trade with Pullbacks?
A pullback in trading is a commonly used strategy that can yield profits if done right. The key to pullback trading is to identify the starting and end of a correction or its transition into a reversal. Traders often use momentum indicators to ascertain the start of a pullback.
Trading trend pullbacks requires investors to choose from the following:
- Waiting for the trend to resume without taking any action
- Closing a position and opening once after the trend resumes. Swing traders often use this strategy
- Trading against the trend till the pullback ends
- Depending on fundamental data waiting out the pullbacks. Long-term traders often use this strategy.
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How to Make Investment Decisions in Case of a Pullback?
Keep these factors in mind while investing during a pullback:
- Focus on the Fundamentals: It is important to study earnings reports and concentrate on the basics to find out whether a company is facing issues or it is just a temporary pullback.
- Wait it Out: An established trendline often measures whether a pullback breaks through support. In such a case, it can be a reversal instead of a pullback and thus waiting to see how the pullback goes could be a good strategy.
- Keep an Eye on Stock Volumes: If, during a decline, the stock volumes increase, it could mean that selling is gaining prominence in the long term.
5 Pullback Strategies You Should Know Of
Here are the most common pullback strategies:
1. Breakout Strategy
This is one of the most common stock pullback strategies. Breakout pullbacks occur mostly at market turning points. The strategy includes the price breakout of patterns like triangles, head and shoulders, rectangles and wedges. Traders using this strategy must not move stop loss to break even as that can be dangerous. This is because breakout pullbacks are quite frequent.
2. Horizontal Steps Strategy
This strategy looks at the natural movements of the stock prices and thus the nature of the market behaviour. The price of the stock shows stepping patterns during the trending phases.
The horizontal steps strategy complements the breakout strategy. This is because it helps to find alternate entry points if the first entry opportunity has been missed due to pullbacks exceptionally close to turning points. This strategy can also be used to safely pull stop loss behind a trend. This can be done by waiting until a step is complete and pulling the stop loss based on the previous pullback.
3. Trend-line Strategy
This is also counted among the common pullback strategies. It requires validating 3 contact points. Traders can choose to connect 2 random points but a trend-line can be formed only when there is a third point to connect.
This strategy takes a long time for validation and that can be regarded as a major disadvantage. Pullback trading on a trend-line can happen only on the third, fourth or fifth contact point. Traders can implement trend-line pullback correctly by pairing it with other strategies. Using it alone can lead to missing important opportunities because trend-line validations take a long time.
4. Moving Averages Strategy
The moving averages strategy is the most commonly used in technical analysis. It is also used in pullback trading. Traders use 20, 50 or 100-period moving averages based on whether they trade in short-term or long-term. Short-term traders use shorter moving averages and long-term traders use longer ones. While long-term moving averages move slower than short-term, they are less vulnerable to wrong signals.
5. Fibonacci Strategy
Fibonacci levels are known for their efficacy in the financial markets. Traders also use this strategy for pullback trading. It involves waiting for the emergence of a new trend and drawing the A-B Fibonacci tool from the origin to the end of the trend wave. Point C of the Fibonacci retracement is used to pull back. Traders can also combine Fibonacci pullback and moving averages into a single strategy.
Throwbacks and Pullbacks: Key Differences
Pullbacks and throwbacks are two opposite patterns that occur frequently in the stock market. When the price goes below a support, retraces back to it, but the support now starts to act as resistance and rebounds from it thereby continuing downward, it is called a pullback.
A throwback is the exact opposite of a pullback. It occurs when the price crosses an established resistance, goes back to the resistance and the resistance now changes roles, acts as support, and bounces back up.
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Final Word
Pullbacks are significant opportunities for both short and long-term investors. However, they also pose significant risks. It is important to identify pullbacks at the right time and join an uptrend at a good price to reap notable returns.
Pullbacks also have drawbacks. Investors may misread reversals as pullbacks and suffer losses. It is thus important to stay in touch with fundamentals and news to avoid mistakes.
FAQs
Ans. Pullbacks are a temporary decline in stock prices after long periods of increase in prices. The decline is normally in the 5-10% range and the uptrend soon resumes after the pullback is over.
Ans. Pullbacks allow investors to benefit from uptrends in markets by entering at a discounted price during the temporary decline. They can buy at a lower price during the decline and sell during the uptrend.
Ans. Pullbacks are caused by sudden changes in market sentiments. This can be due to political reasons, world news, or doubts regarding a company’s performance.
Ans. Pullbacks and reversals both follow uptrends. However, pullbacks are short-term downtrends, whereas reversals may continue for longer periods.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
