If you have been involved in the markets for more than a short while, you have probably heard the expression “The Trend is Your Friend.” In fact, it is so common that it almost seems trite. Maybe it is, but that doesn’t mean it’s not true. Simply put, over the years many traders have concluded that it is generally a higher probability strategy to trade with the current flow of money, rather than paddle upstream.
Let’s say, then, that you too decide to swim with the current. Is there a strategy that lets you dive in but decreases the chance of immediately drowning? The answer is a resounding “yes!” Welcome to “The Pullback”
As the name suggests, a pullback is a short term move in the opposite direction of the longer term trend. It can offer an opportunity to join the trend without chasing the stock. But trading pullbacks can be tricky. Let me share with you some hard won insights about entering and exiting this type of trade.
The first one is trying to figure out if a pullback is simply a pullback and not the beginning a trend reversal. You never know for sure, but here are a few clues I look for.
First, I’ll look at the volume pattern. Has there been less volume in the pullback than in the previous up-leg? If not, the sellers might be gaining power and I’ll generally pass.
Next, I’ll double check to make sure that earnings or other anticipated significant announcements are not coming out over the next week or so. I don’t want to take the risk of the stock gapping down right after I enter.
Then finally, and perhaps most importantly I’ll take a look at the last trading day. Has the stock pulled back to a price that buyers might find attractive? This could be a previous low, an uptrend line or a supporting moving average. And now consider this: what does a retracing stock have to do if it is going to back up? Doesn’t it have to trade above the high of the previous day? Sure, it could trade through that high and then reverse, but if it is going to back up then it has to trade through that previous high. Waiting for that simple confirmatory signal has saved me more times than I can count.
Now let’s discuss actually entering the trade. Naturally, I want to enter as soon as yesterday’s high is exceeded. But since I can’t always look at the market constantly during the day, I’ll place an automatic entry order the night before. I generally use what’s called a stop limit order. Let me explain why. Let’s assume the previous high was 37.50 and I want to buy if the stock pushes above 37.60. I can’t use a limit order to buy at 37.60 because I could get filled at 37.60 or lower, and that is not what I want. I only want to enter if the stock is breaking up through 37.60. I could use a buy stop at 37.60, but since regular stop orders turn into market orders when triggered, what happens if the stock gaps up to 42 on the open due to overnight news? With a stop order I would buy at 42. Again this is not want I want. So instead I’ll use a stop limit.
A stop limit is placed with two prices, the stop price and a limit price. When the stop price is hit, the order turns into a limit order, not a market order. In my example it might read, “Buy 1000 shares at 37.60 stop, 37.85 limit.” If the stock gaps up beyond 37.85, I probably won’t buy it unless the price should drop back to or below $37.85.
So much for the entry criteria. Now for the exits. I generally set an initial stop under the low of the pullback. The rationale is that for a stock to keep trending higher it has to make higher lows. If it violates the previous low this would no longer be the case.
I generally have two initial targets. The first is the previous high before the pullback. Old highs can often act as resistance and it’s possible that the stock could test it, fail and reverse, so I’ll sell a little bit. At the same time, I’ll also raise my stop on the remaining position to attempt to break even. I don’t want a potential winner to turn in to a loser.
I set the second target based on what is called the “measured move.” I’ll look at the distance the stock traveled from its last swing low (the low prior to the current pullback low) to its last swing high (the most recent high prior to the current pullback) and add that amount to the low of the current pullback. How much will I sell there? It depends. If the market has been strengthening and the stock’s sector is showing good relative strength to the market I’ll sell less than if those criteria are not met.
But I will usually not exit the full position at that second target. I want to keep a portion of it to see if I can capture a much bigger move. I manage this last part of the position with a mental trailing stop, usually based on a supporting moving average. For example, if I’ve noticed that the stock hasn’t violated its fifty day moving average for quite a while, I’ll exit when it finally does. I tend to base this decision on closing prices, since middle of the day movements through support and resistance levels are often on low volume and not that meaningful to me. Institutions tend to trade more actively in the last trading hour and volume picks up, especially in the last twenty minutes. If they won’t support the stock and want out, then so do I.
There are probably as many trading strategies as there are traders. Over the years, pullbacks have worked for me. Regardless of the method you choose, follow your entry rules, honor your exits and try your best to keep your emotions in check.
Lee Bohl can be contacted at Charles Schwab