How To Use TM's Indicators: The Pullbacks From High/Low Lists

Pullback Defined

Before a pullback can occur, the market should be in a trend and must make a new high. This new high should be at least a 1-month high (20-22 trading days) and, preferably, two months (40-45 trading days) or more. The stock should then have an orderly sell off of, on average, three-to-seven days. This is known as the width of the pullback. The amount a stock corrects is known as the depth. Essentially, pullbacks should be deep enough to flush out the weak hands but not deep enough to be categorized as a new downtrend.

Also, corrections tend to be deeper in volatile markets that attract fast money, requiring a looser pullback definition. For example, a deep correction in a hot technology stock is more acceptable than one in a consumer cyclical issue. Therefore, less volatile stocks may only correct (say 5%-10%) before resuming their uptrends, while more volatile stocks may correct 15-20% or more. Keep in mind that the above are general rules of thumb for defining a pullback. Each market should be evaluated on a case-by-case basis.

Trading Pullbacks

As mentioned above, the market must first be in a strong trend (a) before a pullback can occur. Once the pullback occurs (b), look to enter if, and only if, the trend begins to re-assert itself (c). Once filled, place a protective stop below the low of the setup (d), just in case the correction has not completed itself.

No Tickee, No Tradee

When you begin to analyze a pullback, you have no way of knowing if this is just a normal (and healthy) correction or the start of something bigger. One of the simplest, yet possibly most important aspects of about trading pullbacks is to wait for an entry.Trading pullbacks is not about fading the market. As mentioned above, the idea is to enter if, and only if, the trend begins to re-assert itself. By waiting for this entry, you can often avoid markets that have topped out. The figure below illustrates a market that failed in its pullback, but did not offer an entry.

Real World

Looking below to Symantec, we notice that the stock is in a strong uptrend (a) and then begins to pull back (b). An entry is triggered above the prior day's high as the trend resumes (c). A protective stop is then placed below the low of the setup (d), just in case the correction is not complete.

Here's an example on the short side in the BroadBand Holders. Notice that there were in a strong downtrend (a) and then began to pullback (b). An entry is triggered below the prior day's lows as the trend resumes (c). A protective stop is then placed below the high of the setup (d), just in case the correction is not complete.

Identifying Pullback Candidates

Trading Markets publishes a list of the 30 strongest stocks that are in pullbacks nightly it its Pullbacks Off Highs List. For short candidates, Trading Markets also publishes the 20 weakest stocks that have pulled back in its Pullbacks Off Lows List. For those wishing to get a head start, you might consider monitoring the various momentum such as the Proprietary Momentum List, New 60-day Highs on Double-Volume List, Momentum 10 Technology List, etc. Many times, stocks will show up on these lists long before they make it to the pullback list.

Choosing The Best Setups

Not all setups are created equal. Ideally, a stock should be in a strong trend, it should be persistent (i.e. follow through from one day to the next) and it should be in one of the strongest sectors (for longs). For more on picking the best stocks, see the article on stock selection under Traders Lessons.

Also, there's no substitute for experience. If you are fairly new to trading, look at the pullback list(s) that are generated nightly. Study these stocks over the next few days. Question which one worked. Question which one didn't. Ask yourself: What were the market dynamics? What were the sector dynamics? What made one setup better than others?

Money Management And Position Management

No strategy is complete without a risk control plan. Although placing your order above the market helps ensure the market is moving (at least temporarily) in your direction, it in no way guarantees a pullback is complete and the market will resume its up trend in full force. As a result, it is necessary to protect yourself with stop order.

As mentioned above, the most logical place for a protective stop is below the lowest bar of the pullback. If the move turns out to be a much deeper correction, or the beginning of a new downtrend, you will (hopefully) be stopped out with only a small loss. Professional traders are willing to take several "stabs" at a market, keeping risks small, in the hope of capturing a larger move.

Money management is crucial to any pattern or style of trading. However, it's beyond the scope of this article to cover it in detail. The good news is, there are plenty in depth articles on the topic under the Money Management section of Traders' Lessons.

Summary

In summary, pullbacks are fairly simple yet often effective technique for entering markets that are in strong trends. The idea is to wait for the market to have a normal, and often healthy, correction, then look to enter that market if, and only if, the trend begins to re-assert itself. Protective stops are used below the low of the formation just in case the correction is not over. Trading Markets publishes a list of potential pullbacks nightly along with momentum lists of stocks that could be the next pullback candidates.

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