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Pullback Trading Explained 

Last Updated: March 2, 2021

By Rayner Teo

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In today’s episode, what is pullback trading, why it works, when to trade, and how.

So tune in right now…

Resources

Pullback Trading: 5 Things to Look for Before You Place a Trade

The Definitive Guide to Trading Pullbacks and Breakouts

Price Action Trading: 6 Things To Look For Before You Place A Trade

The Complete Guide to Stop Loss Order

The Complete Guide to ATR Indicator

Transcript

Hey, hey, what’s up my friends? In today’s episode, we’ll discuss pullback trading.

What is pullback trading?

First and foremost, what is pullback trading and why does it work? In essence, what you’re trying for pullback trading is to buy the dips, the retracements, the correction in an existing trend.

For example, if the market is trending higher, you’re looking to buy the dip, to buy the retracement, to buy the pullback. That’s why it’s called pullback trading. And the reason why this works is because when the market is trending, it doesn’t go up in one straight line.

Instead, in an uptrend, you can expect to see a series of higher highs and higher lows. As a pullback trader, what you’re trying to do is to time your entry on the pullback, the retracement, the correction. Makes sense? That’s what a pullback trader tries to do.

Pullback trading vs catching a falling knife

Now, you might be thinking, “Rayner, what’s the difference between pullback trading and catching a falling knife?” That’s a good question.

As mentioned earlier, as a pullback trader you are trying to trade in the direction of the trend, but you’ll look to enter when the market is sort of going against you on the retracement move. But you’re still trading in the direction of the trend.

Whereas someone who is trying to catch a falling knife is pretty much trying to fish for the bottom of the market especially when the market is declining in a downtrend but you’re trying to catch the bottom. That’s the main difference between trading a pullback and catching a falling knife.

5 simple steps to trade the pullback

There are a few things to look for on trading a pullback.

#1: Market must be trending

As mentioned earlier, when you trade pullbacks, you’re trading pullbacks in an existing trend. You must have a trend because without the trend, you’re not able to catch a pullback. You’re not trying to catch a falling knife; you’re trading a pullback.

First and foremost, trade in the direction of the trend. Identify an existing trend, and then we can look to trade pullbacks in it.

#2: Identify the area of value

Here’s the thing, just because the market is in an uptrend doesn’t mean you want to blindly hit the buy button. Instead, you want to be trading from an area of value. An area of value could be things like a swing low, support, trend line or a trend channel.

These are potential areas on your chart where buying pressure could step in. This is what we call an area of value.

#3: Look for an entry trigger

Yes, the market is trending higher. Yes, it has made a pullback towards an area of value. But it doesn’t mean that we want to blindly hit the buy button. Yes, we can. But that’s a separate thing altogether.

As a pullback trader, you want to look for a specific entry trigger to let you know that the buyers are stepping in, they are in control and they’re about to take the price higher.

An entry trigger could be something as simple as reversal candlestick patterns like a bullish hammer, a bullish engulfing pattern. That’s an entry trigger for us to time our pullback to get on board the trade and to join the existing trend.

You’ll only look for the entry trigger after the first two conditions are met, number one, an uptrend and number two, the price retracing towards an area of value, then we look for the entry trigger.

#4: Set your stop loss

Since you’re trading pullback, the next question is, where do we set our stop loss? Logically, if you’re trading pullbacks, then your stop loss should be below the lows of the pullback.

This means that if the market rallies higher and breaks below the lows of the pullback, it tells you that this pullback has failed, and you want to get out of the trade.

You’ll have to identify the lows of the pullback and give some buffer below the lows. You can use the ATR indicator for it.

Let’s say the low of the pullback is $100. And let’s say you pull out the ATR indicator, the average true range of the market is $5. You can simply take $100, which is the low of the pullback, minus $5. Your stop loss is at about $95, a small buffer below the low of the pullback.

#5: Set your take profit level

Where do you take profits? Generally speaking, if you’re trading in the direction of the trend, what you can do is to reference the extreme swing high to take profits. When you’re trading pullbacks, you’re buying the dip when the market has retraced against you.

If you look prior to retracement, you should be able to identify a swing high on the chart. That swing high could be a reference point for you to take profits.

If you’re looking to buy the pullback, you went long and the market is moving in your direction, you can look to take profits just before the swing high.

Why not after the swing high or why not at the absolute swing high? Simply because swing highs and lows, support resistance and like that, are not specific levels on your chart. They are areas on your chart.

This means that the price could come close to the swing high but not reached the exact price point and then start to reverse from there. It’s possible because you’re dealing with an area on your chart.

If you don’t want to watch your open profits come close to your target, only to do a sudden reversal and hit your stop loss, then what you want to do is to set your profit target just before the recent swing high.

Pros and cons of pullback trading

What are the pros and cons of pullback trading?

Pros of pullback trading #1: Psychologically easy to trade this type of strategy

Because you’re in essence trying to buy low and sell high, to buy the dips and then to sell the rally.

Pros of pullback trading #2: Favourable risk-reward

Compared to let’s say someone trading the breakout of the highs, by the time the price reaches the swing high you are already in profit. You can see that from a risk-reward standpoint, it’s favourable to you as well.

Cons of pullback trading #1: You may miss the move

You may miss the move sometimes if the pullback doesn’t come to your area of value.

Cons of pullback trading #2: Not suitable for impatient traders

If you’re not a patient trader or you have no patience to wait for a pullback, this strategy might not be for you.

These are kind of the pros and cons of pullback trading. Let’s do a quick recap.

Recap

  1. Pullback trading is, in essence, trying to buy the dips, the retracement, the correction in an existing trend
  2. You must trade from an area of value if you want to trade pullbacks
  3. You must look for an entry trigger
  4. You can set your stop loss just below the low of the pullback
  5. You can take profits just before the most recent swing high in the trend

With that said, I wish you good luck and good trading. I will talk to you soon.

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