In-depth Analysis

Everything You Should Know About Pullback Trading

It is essential to choose your trading style based on your personality, risk appetite, and financial goals (among other criteria) to get started in trading.

Once you have determined the type of trading you are going to use, you need to think about a specific strategy for when to enter and exit the market. Some traders are particularly fond of pull backs for opening and closing their trading positions.

What is a pullback in trading? What are the benefits and risks of using it in your trading? How can you take advantage of it? All these questions and more are answered in this article!

What is pullback trading?

Explanation

Pullback trading is based on the fact that prices never move in a straight line within any trend. Whether it is an uptrend or a downtrend, prices alternate between up and down phases in the direction of the primary trend.

Pullbacks represent corrective movements within the main trend. They can therefore be compared to pauses in the overall upward or downward price movements. They often move to former key price levels, such as supports and resistances levels.

In the case of an uptrend, pull backs would be temporary downward movements, moving toward supports. Conversely, if there is a downtrend, then pullbacks would be bullish price movements that move towards resistances.

Easy example

Let’s say the UK100 stock index (FTSE 100) has just broken through a resistance level at 7,500 points and continues to rise to 7,575 points. Prices are pausing and returning to 7,500 before resuming their bullish course. This return to the 7,500 point level before moving to new highs is what we call a pull back. The former resistance of 7,500 points has become a support level.

Now, let’s imagine the opposite situation, namely that the UK100 stock index is in a downtrend. After a strong price movement downwards that breaks the 7,500 point support, prices catch their breath after reaching 7,435 points by moving back towards the former support now turned into a resistance level at 7,500 points before moving downwards again. This movement is a pullback.

Pros of using pullbacks in your trading

  • This method is used by many types of traders in different financial markets.
  • It is a technique that allows you to open a trading position on a pullback to potentially improve the success of your trading strategy.
  • pullback trading allows you to trade in the direction of the trend.
  • It is a relatively simple trading style to incorporate into your trading.

Cons of using pullbacks in your trading

  • pullbacks are not always automatic after a strong price movement. If you wait for a pull back to materialize, you may miss some trading opportunities.
  • It is possible to mistake a pullback for a trend reversal, which can lead to significant losses if you don’t have risk and money management rules in place in your trading plan.

If you want to optimize your trading positions with better money management rules, check out our SmartCalculator.

Pullback vs reversals

It is important not to confuse pullbacks with reversals.

While a pullback is a pause in a trend, and therefore a temporary movement, a reversal is a profound change in investor sentiment that pushes prices in a new direction for some time.

There is of course the risk of not considering a pullback as a trend reversal, but your experience should allow you to quickly learn to tell the difference.

One tip is to look at the big picture from a fundamental and technical perspective.

The importance of support and resistance

Since pull backs are mainly used by technical traders, key price levels play an important role in pullback trading. That’s why we want to go over the concept of supports and resistances in this part.

Supports and resistances are psychological price levels on which prices can react. That’s why they are very closely watched by technical traders and stock orders usually accumulate there.

A support is a level that tends to stop a downward price movement, while a resistance tends to slow down an upward price movement.

During pullbacks, prices usually move towards previous support and resistance levels. That’s why it’s essential to know how to spot them when trading pullbacks.

What are the best trading tools and indicators to trade pullbacks?

To trade pullbacks, you need to have some knowledge of technical analysis.

First, you need to use technical tools and indicators to spot the main trend of an asset via moving averages, rectangles, trend lines, and price channels for example.

Next, it is important to spot when prices are going to accelerate in one direction (breakout), as pullbacks usually occur after a sharp rise or fall in price. When pullbacks happen, tools such as supports, resistances, pivot points, or Fibonacci retracements can be useful in anticipating the levels that pullbacks will target.

Finally, it is important to look for other indications or confirmations of price acceleration or pullbacks to improve your entry or exit strategies. It will then be easier to set up your protective stop-loss or take-profit orders, for example.

 

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