- November 11, 2021
- Posted by: CoachShane
- Category: Trading Article
Looking for pullbacks on a chart is a very viable approach to trading any market.
- Find a strong impulse move in the instrument
- Wait for a corrective decline (for an uptrend)
- Buy when strength is returning to the instrument
The challenge comes when a simple pullback (1 – leg down) turns into a complex pullback (multiple legs down).
Why is this a challenge?
If you go long near the bottom of the simple pullback and it turns into a complex pullback, you will no doubt take a loss on the trade.
Is there a way to find a probability of one pullback type over another?
Will this prevent losing trades?
Traders must think in probabilities, not certainties. This is the main reason your protective stop is the most vital order you can place.
2 Ways To Determine Probable Pullback Type
There are two ways a trader can put the odds in their favor when looking at a pullback to trade:
- Rule of alternation
- Overextended price
These are simple approaches that work. I use both in my own trading as do many traders I know.
Rule of Alternation
This rule essentially is the repeated occurrence of two things in sequence.
If your last pullback was a simple correction, the next one has the higher odds of being a complex correction.
After the complex correction would be a simple correction.
Keep in mind that each time frame will have a slightly different look. A simple correction on a daily chart may be a complex correction on the four hour, hourly, or another day trading time frame.
Chart patterns are not always as clean cut as the last one on this chart. The complex pullback is more representative of what the average chart pattern will look like. Don’t expect perfect looking patterns.
This is one reason I speak of concepts; we are trading concepts and not the pattern itself.
After seeing a complex correction, be aware that the next pullback may only be one leg and look for strength on the reversal for your trade entry.
This is often referred to as an oversold or overbought instrument.
You can also see an overextended market by looking at large price bars after a series of smaller ones. You will see a change in character in price that shows that something has changed in the buying or selling pressure. This is useful information.
Notice the difference between the first set of candlesticks in the middle of the trend and the last set.
The average true range reading went from $1.02 in the middle of the trend, to $1.37 at peak. The pullback is clearly not a simple pullback like we see in the middle of the chart.
Adding in the Bollinger Band shows price above the upper band and a widening of the bands which is a sign of strength.
It is also the end of five days of sustained buying pressure. A momentum thrust down (3.5% in one day) leads to a complex correction that is currently underway when this post was published.
Combined, this all points to expect a complex correction.
Multiple Leg Pullbacks
A complex correction is generally defined as two corrective swings. That is a simplistic way to look at it as we can have multiple legs in a correction.
On this daily chart, price continues to pull back all the way down to fill a gap.
There are multiple lows that you may have looked to enter at depending on what you use for an entry trigger.
It took four reversals to finally follow through as price went on to make new highs.
The question now is: How many reversals will you attempt to trade?
If you stuck with the rule of thumb using 2% risk, you were down 6% before being rewarded.
Can we now look for something in price that shows a higher probability of a positive reversal?
Loss of Momentum
Keep in mind, again, that there will always be exceptions and that we are just looking at the probability of one thing happening over another.
In this case, the reversal that actually worked showed a different character than the other lows.
Instead of quickly reversing off of lows, price in this example pauses showing, at least in the short term, lack of further downside.
It is around this area you would look to enter. If you think this looks like a small trading range, you would be correct. You can read this article on trading breakouts as one way of entering long when this occurs in whatever you are trading.
It Is Not Perfect
While not a guarantee, at least you are using structure and market rhythm instead of just jumping into a trade.
If you do happen to enter thinking you have a simple pullback and it rolls into a complex correction, where is the probable failure points?
This example is not the best as the red circle highlighting the long upper shadow indicates some type of exhaustion of price to the upside (yes, another clue of a complex pullback coming).
However, if you went long on the small red candle, price moved to the upside on low momentum and failed “around” the pivot high.
One you see price reject that zone making it resistance, you’d be wise to start managing the trade or getting out.
We can always re-enter a trade.
The key is to look for dying momentum after the reversal. We would expect buyers to enter to help propel price if there is any hope for a break of highs and continuing of the trend.
This was not meant to be a full course on trading pullbacks. You can find that at the blog post “Profit from trading pullbacks“.
What we did cover is an important piece when looking for continuation trades. We want to put ourselves in the best position to profit and any edge, is a good edge.
To do that, we have to have some idea of what a higher probability is of one thing happening over another.
If you are looking for the perfect chart pattern including bull flags to buy, or others to sell, chart patterns are often messy.
Looking at the overall structure as well as the presence or lack of momentum, is what is important.
Perfection is only in the textbooks.