Spotting and buying a pullback is one of the oldest and most basic principles in investing or trading. It’s not easy to do, as you can never predict whether a decline is a short-term pullback or the beginning of a larger downturn. But there are a few principles you can follow to make the process a bit more, if not easier, then objective.
Is it Time to Pull the Trigger?
You’ve been following an asset for some time, just waiting for the right moment and price level to get in. Now, its price has declined. How would you know if it’s now the right time to pull the trigger? How would you know that you’re not merely jumping the gun? If you are not planning on “holding it for the long term, at what level would the “trade” no longer be valid? If you’re planning a swing trade, at what price levels might you consider taking profits?
These questions, each posing their own challenges, are nothing new. Traders and investors often face these questions every time they place a trade. They make a big difference if you don’t have your own answers and solutions to them. And if you don’t, then either you’re new to this game or you are engaging it haphazardly.
So here are a few pointers to help you figure things out:
1 – Pay Attention to Volume
Trading volume is not a definitive indicator, but it might help distinguish a minor pullback from a potentially major decline. The common-sense reasoning goes like this: if an asset price is falling, and if volume is dwindling, then chances are that investors aren’t dumping the asset en masse or trying to plunge it downward (as in short sellers). Of course, a low-volume decline can turn into a high-volume crash, so watch out for this, as it can change the entire picture.
2 – Check Fundamentals and Economic News
Is the decline an appropriate response toward weakness in the asset’s fundamentals or sector, or might it be an over-reaction triggered by a direct or indirect fundamental factor? Remember that market sentiment is comprised of multiple and perhaps conflicting goals, strategies, and responses. In other words, overall response may be a smoothing-out of heterogeneous actions. So if you are not checking fundamentals and relying solely on technical factors, then your evaluation may be based on this mass of confusion hidden within a majority move (and when things begin going sideways, market heterogeneity becomes even more pronounced).
3 – At What Price Might the Trade No Longer Be Valid?
If you buy pullbacks enough times, you are going to be wrong more than just a few times. Of course, managing your positions so that your upside is greater than your downside is key (but that’s for another article). But when you enter a trade, you should at least establish a price level at which your bias might no longer be valid. This is where you might want to place your stop loss.
4 – Do You Take Profits or Let Them Run?
Let’s suppose you are not looking to hold a position for the long term. Instead, you are looking to place a short-term swing trade. How much (profit) is enough? Of course, there are many different answers to this question. If you are new to swing trading, then we can at least introduce two of them:
- If your asset is truly in an uptrend, then chances are that price will once again reach and exceed the previous high.
- If price exceeds the previous high, and if there is no other recent high in sight (e.g. if it is making entering into new-highs territory), then you might want to consider utilizing a “measured move” approach (it’s not always accurate, never predictive, but it’s a way to set an objective point of reference).
A measured move is determined by subtracting the previous swing high from the swing low that preceded it and adding the figure to the low point of the correction. The “theory” is that in an uptrend, the asset will reach that equivalence in price. Again, it’s just a theory. But it also serves as a frame of reference.
Example: If an asset begins its uptrend at a low of $10, reaches a high of $20, and then pull backs to $15 before continuing its uptrending movement, then a measured move (20-10 = 10) of $10 would be added to the pullback low of $15, projecting a potential move to $25 (15 + 10 = 25).
Simple, right? It’s supposed to be. Again, it’s a point of reference. But it can also be useful depending on how you manage it.
Here’s an example:
At (1), you notice a pullback on Apple Inc stock, noting that the price decline happened on low trading volume. At (2), you decide to buy a breakout of the lowest low’s high, placing your stop loss below the previous bar’s low, as you’re assuming (or hoping) that might be the low point of the pullback. Your first profit target is the the previous swing high at 219.20 which is reached at (3).
You decide to set your next profit target at a measured move starting at the most recent swing low at 213.85. So, you subtract the previous swing high price (219.20) from the swing low that preceded it (204.50) and get the figure of 14.70. You add that figure to 213.85 and get the price level of 228.55. Setting your next profit target at that price, it is triggered three sessions later at (4).
Like every trade attempt, there will be times when this approach doesn’t work. It’s not a surefire system. But it is a relatively simple, objective, and a clear way to buy pullbacks. And sometimes, especially for new traders/investors, that’s all you need.
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