Traders Ask: Pullback or Reversal?

BellaMike Bellafiore's (Bella's) Blogs, Traders Ask11 Comments

Hi Mike

A common mantra repeated in most trading books is “follow the trend” and the process for doing so buy/sell through dips. Sounds easy however there are multiple complexities rarely discussed such as:

 

– Few stocks continue in a nice straight line
– The stock you’re watching is in a great bull trend, but the market is weakening or turning
– Recent market activity has been very volatile and  stocks that were moving in a line now have a great big dip
– The major trend line has broken but the move has resumed at a different angle etc.

Do you have guidelines you provide your traders to try to help identify a trend and differentiate a pullback vs. reversal? What is it about a reversal that defines the move as a new trend as opposed to a pullback or deep pullback? When doing this for a stock, how much emphasis do you put on the market doing the same?

At present I’m making discretionary decisions and would like to put a system in place to get more mechanical in making the definition if possible. Any assistance you could provide would be much appreciated. Thanks :-).

Bella Responds

You are so on to the proper path to figuring this out. I love your work of identifying the nuances for these pullbacks. I love you trying to make your decision making more mechanical or logical for these set ups. Great work organizing your thoughts and reaching out for help so you can grow as a trader.

There is absolutely no way I can offer you a definitive way to trade pullbacks in this blog. The market is too nuanced for that. But if you continue the thinking that you are doing in this question above you will find the pullbacks trades that make the most sense to you.

A few thoughts from me:

1) I draw trendlines mechanically and then use my judgment. I am not a slave to whether the stock technically has broken this thin line that I drew. I look at the more important levels from the move. Where did the stock break out from?  When it did where did it pause? I am more focused on whether a stock is above or below important levels to me than just the trend line.

2) I know my pullback trades that work best for me:

a) shallow pullbacks

b) pullbacks to areas where the stock broke out from

c) pullbacks to the trendline with strength on the tape

d) pullbacks to the trendline or important level with the market gaining strength

e) I pass on pullbacks that I am not confident about (perhaps like now the market is really selling off)

Ok I will stop here as again I can not offer an exhaustive list of my best pullback trades and their nuances in one post.  But I do have a list.  And I do adjust my pullback trades for the many affecting elements that you are starting to think through.  This is the spot on process that you must go through as a trader.

You can be better tomorrow than you are today!

Mike Bellafiore

One Good Trade
The PlayBook

No relevant positions

11 Comments on “Traders Ask: Pullback or Reversal?”

  2. One of the best discussions on the subject is in Al Brook’s book. He talks about how trend progress and then end and reverse. It’s well worth the time and effort required to get through his book.

  7. Hi Andrew. I have read Al’s book and turn to it regularly as the bible as such, it’s a great book. I’ve tried to use Al’s ideas of breaking trend lines and 2 legs in a move since reading. His observations of retests of the break high/low have become one of my primary rules as I’ve since observed it happen so regularly, as has his ideas of thinking in legs. However as great a job as Al does I don’t think he really gave much of a definition for how to spot the new trend except perhaps for a reversal off a pullback or failed breakout once the new trend is in place. Perhaps it’s time for me to have a re-read !!!

    Certainly I’ve observed plenty of times that breaking a trend line in a pullback most certainly does not always mean a reversal – if the market remains strong the trend more often than not continues on a different angle and this is very hard to spot and trade with confidence.

    Agree with your comment however and thanks for offering assistance. Al’s book is incredibly hard to read but one of the best (alongside Mike’s of course 🙂 ).

  8. Pullbacks have pretty much been my main trade for many years… I wrote a couple posts on RIMM that dealt with exactly this question of what pullbacks were tradable. And remember… it’s all probabilities, nothing is ever certain.

    I don’t think it’s possible to build a pure system to do this, but the key is to understand where the pullback is in the trend structure. You probably want to be buying roughly 30 – 60% retracements. I’m suspicious of very shallow retracements (unless the FIRST one) because these tend to develop into two legged pullbacks. Al’s book is the best written source (currently) for this… I posted some info on his book a few weeks back too.

    You are asking the key question to trading pullbacks… I think pullback traders also need to have a complete understanding of trend reversals because these are your failed pullback trades.

  10. Fibonacci… be careful. I think it’s one of those things that works better in hindsight than in actual trading… and also many people will draw 40 fib levels on a chart and then point to the one that “worked” perfectly. As you might have guessed, this is one of my pet peeves. 🙂

    However, the concept that you want to be buying retracements at about 50%… that is valid. You don’t want to buy too shallow or too deep. I have a fib grid that has simple lines at 33% and 66%. Sometimes I will put that on a chart as a reminder to try to buy in that zone, but I never use Fibonacci strictly.

    Make sense?

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