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Trading pullbacks – trick or treat?

trick or treatFor technical trend traders there are quintessentially only two ways of trading the trend – on a breakout or on a pullback.

As the names suggest, to trade a breakout you must wait for price to break above/below the most recent high/low. And to trade a pullback you must wait for price to pullback from the current trend and anticipate the reversal.

Many traders new to trend trading want to trade the pullbacks, as to do so could mean maximising the pips/points extracted from a trend.

Is the treat of the extra profit worth the trickiness of trying to predict a pullbacks reversal point?

Advantages and disadvantages of a breakout strategy

The main advantage of trading breakouts is that you are definitely trading in the direction of the trend.

Technical trading is all about probabilities, so by trading in this manner you are increasing the odds of the trade going your way. You can read about it in Javid Shaik’s excellent article “Don’t buy tops or sell bottoms” on how to identify and trade a trend using breakouts.

The major disadvantages are threefold:

First, you need to make sure your system allows for fake breakouts. However, there are many ways of minimising this risk, such as waiting for the second or third breakout bar.

Second, after a breakout price will at some point retrace. Sometimes this is fairly soon after being triggered into a trade and your position can dip into negative territory (until the trend continues). To reduce the risk of being stopped out make sure your stops are at a reasonable distance to allow this natural movement to play out.

Third, you may be entering at the final phases of a trend – so price will reverse and stop you out at a loss. There is little that can be done about this scenario (other than to tighten your stops if your indicators stipulate this is indeed occurring) and it is also true of a pullback strategy.

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Advantages of a pullback strategy

The main advantage of a pullback strategy is the extra pips/points you accumulate over the trend.

In a neat, linear trend this extra profit can be quite substantial over a period of several weeks or months. If the pullbacks are regular and deep the additional profit will be even more pronounced. If the pullbacks are regular but shallow, then the advantage over a breakout strategy is reduced, but still noteworthy.

Another advantage is that your stops can be placed closer to price action. If the pullback does not reverse, as expected, you want to be out of the trade sooner rather than later.

The two advantages here are that either your position size can be larger per pip/point (and a subsequent move in your favour will carry more profit per point/pip) or your total risk can be smaller (so if stopped out at a loss your loss would be a smaller monetary amount).

So far it looks like pullback systems have all the advantages over a breakout system. But are the treats really so easily in the bag?

Disadvantages of a pullback strategy

The main disadvantage of a pullback system is being able to identify the extreme point (the lowest low or the highest high) of the reversal.

As with any trend trading strategy you have to wait for the trend to become established before it can be traded. There is always a tradeoff between getting in too early or too late. But with a pullback strategy you also need to establish the character of the pullbacks.

Are the pullbacks sharp and deep, shallow and prolonged, or small and regular? What other identifying marks do the pullbacks display?

There are a number of questions you can ask yourself to identify the reversal point of the pullback:

  • Are there good continuation patterns such as flags or double bottoms/tops?
  • Do the pullbacks tend to reverse on a Doji or engulfing candle?
  • Does the extreme of the pullback coincide with an area of previous support/resistance?
  • Does price bounce nicely from a trend line, regression trend channel or similar?
  • Can retracements levels (e.g. Fibonacci) identify the depth of the pullback?
  • Does an overbought/oversold indicator occur simultaneously?
  • You may want your system to incorporate one or more of these events to anticipate the extreme of the pullback. A final question might be:

When does the pullback become a change in trend direction or consolidation?

In my opinion it’s a lot more complicated than trading a breakout. It’s not only more time-consuming, it is also less reliable as there are more factors at play. The more variables involved then the less straightforward and mechanical the strategy – and the more likely mistakes will creep in. There are too many ifs, buts, whens and maybes.

A second disadvantage to trading pullbacks is there is too much pressure on you to be right. As it is more subjective, you have to make an educated guess as to whether the pullback is concluded or not. For many new traders this is wrongly considered to be a major attraction – it is how they can ‘prove’ their natural talent for trading.

While, overall, the markets are fairly predictable (which is why trend trading is so successful a method of trading) there can be random movement at any time. Only a clairvoyant would supposedly be able to read the markets with 100% accuracy.

A final disadvantage is that markets can at times move very fast with pullbacks of maybe only one or two bars. This rarely gives the pullback strategist time to identify and trade the pullback. This is especially common on forex. Not being able to get into a trend is the trend trader’s biggest nightmare.

Mixing oil and water

I have known several new traders who try to combine pullback and breakout strategies. This is generally a bad idea and as foolhardy as trying to blend oil and water.

If you enter a position using a pullback strategy then that is how you should continue to trade that market. And if you enter on a breakout strategy, you should compound using the same breakout strategy.

Of course, it is perfectly acceptable to be a pullback AND breakout trader. Just not on the same stock/currency pair at the same time (the exception being very experienced traders who may do this, for example, on different timeframes).

As a general rule, traders tend to specialise in one or the other. The simplicity of breakouts appeal to some and the more hands-on approach of pullbacks appeal to others.

As with most aspects of trading, there is no right and wrong. Just be aware of the benefits and potential pitfalls and find the system that suits you.

Conclusion

The paradox is that trading pullbacks should only be undertaken by more experienced traders – and yet the more experienced traders tend to prefer the more simple approach of a breakout strategy.

The main advantage of trading pullbacks is purely financial – you aim to get into the trend at a better price point. But to do this the process can become emotionally charged as the exact reversal point can be unclear.

Trading breakouts is more logical and reliable. This simplicity means fewer subjective decisions need to be made.

There are times when trading the pullbacks can be straightforward – when the trend is linear with small, neat and regular pullbacks. But this same scenario is ideal for the breakout trader, too.

Trick or treat? Toil and trouble? Only you can decide.

Hope you all enjoy the holidays.

Anne Chapman

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