The stock market is pulling back. A lot of growing warnings have been put forth in this columb over the past few weeks as the alarm bells were ringing louder. For the bulls though and longer term holders this is just another bump in the road so far and is to be expected when holding long term. For the bears …well they finally have there moment in the sun. Whether they can make more of it remains to be seen. This has been a powerful long term trend up to just reverse the long term trend in one pullback.
Something very pertinent to discuss at this time is how can a trader determine what is happening in the big picture. Is this just a routine pullback or something more ominous? After already accepting the fact that this is the stock market and anything can happen in the short term, there are many tell tale signs that can give clues as to the markets real intention. Just like we were getting nervous that the market might pullback soon a week ago, we can use the same tools to get an idea of how far things could go.
Determining the quality of a pullback should be the subject of a full article (you can search for the previous articles on this site, or pick it out of these articles brought together to help you trade professionally.)
A professional trader will watch price action to observe ‘how’ the market pulls back. Is it controlled and measured, or does it just drop precipitously? Does volume surge or does it wane as it falls? Just how eager do traders look like they are wanting to get out of stocks? How deep does it pullback – what pecentage of the last rally is retraced on your time frame. (This is key as any pullback of any size will put smaller time frames into reversal downtrends.)
A pull back of 20-40% is still in bullish territory. When pullbacks fall to 50-60% of the previous move up most traders will not expect the market to go on to new highs when it reverses. (That does not mean they will not trade the reversal, it means they will decrease their expecations and set targets below the previous high.)
What must be realized by traders is that pullbacks are a necesary ebb and flow of the market and that they offer opportunity in uptrends, rather than gloom and doom. Think about it this way: What better place or time would there be to get back into a stock than when it pulls back and offers more profit potential. Especially if you were brilliant enough to sell it closer to the previous high! Getting in on the beginning of a move is the best time and place to maximize potential profit and minimize potential risk. (It is worth reading that last sentence again and clicking the link.)
Different style pullbacks have different names by some traders, but it is more important to to see what is going on than to memorize names of stuff. Flags, descending triangles, pennants, inside 123’s, are some of the more common names. Some form the parts of some trading patterns, but again it is important to recongize what is going on and the message they send. It is even more important to see them properly through the lens of the current market environment. For example: A buy set up formed during a pullback is a buying opportunity, but only in a market uptrend. Many novices make this error and their account suffers when the market trend reasserts itself and their stock goes on to lose money.
Free markets do not go in straight lines and pullbacks give the market time to rest. Such a rest allows traders to take orderly profits and sell to other traders who want to get in.
So here are some parameters that can be used to help determine the quality of pullbacks and trends:
- The pullback does not go beyond 40% of the immediate prior uptrend.
- It is a best for the stock to pull back to some level of support. This can help reduce risk of the stock falling further after you enter, and is a preferred place to enter a stock.
- The best pullbacks are ones that form a smooth controlled path down and do not move in a choppy fashion. Should congestion be created on the way down it can make it that much harder for the stock to get past it when it reverses and heads back up.
- Many of the best pullbacks fall 3 to 5 bars in a given time frame. If you take a look at several charts (any stocks you choose, any time frame you trade), you will notice a tendancy for many stocks to run 3-5 bars or so in one direction before reversing. This revelation can be a real ‘aha’ moment.
- Many of the best pullbacks do so around a 45 degree angle. If it pulls back too sharply it can be revealing sellers are too aggressive.
- Pullbacks should pull back from a ‘single point’. For example, a single candlestick bar or topping tail (provided it is not too long). Pullbacks that start from a ’rounded’ or ‘square’ top should be avoided. Congestion like this represents more resistance for the stock to have to get through to go on to new highs.
- Volume should be generally less than the previous advance from which it is pulling back from. This can show most holders of the stock are not selling.
If you watch market internals they also usually will give a heads up that conditions are improving. The TRIN, advance/decline ratio, AAII survey, and the McClellon Oscillator that have been covered previously should be showing so or even getting extended. These were a primary reason to susopect the current pullback.
The next logical question after digesting this information is usually, Ok I see the pull back happening within the context of an uptrend. So when do I buy? Lets cover some thougths on that in the next article. We will try to find a Colorado stock to use as an example.
Trade with a plan.