i. A pullback is a short period of price retracement.
ii. Pullback occurs because of a brief trend exhaustion.
iii. Different types of pullbacks based on how far it retraced.
iv. A reversal is when price breaks the previous swing high or low.
What are pullbacks?
When the price is in a trend, it will never move up or down in a straight line all the time. There will be instances where it moves away from the trend.
If you open any price chart of any currency pair and observe trends, you will see that price often moves along the trend and has a minor move against the trend from time to time.
This minor price movement against the trend is what we know as pullbacks.
Once a pullback occurs, the price would then move back to its prevailing trend.
Read ahead to understand why pullbacks occur exactly and why should you even consider trading pullbacks.
Why do pullbacks occur?
I have already mentioned that the price does not keep moving in a straight line. It will move counter trend at times.
This is what the impulse and correction principle is.
An impulse move is in line with the prevailing trend and from time to time there will be a price correction.
These corrections are also known as pullbacks.
So why do these pullbacks occur?
When a price is moving in an uptrend it means that the buyers are outweighing the sellers and they are heavily buying and taking the price higher.
If the price is in a downtrend, then sellers are in control and are actively selling and driving the price down.
This activity of actively buying or selling cannot keep going on all the time.
There are times where buyers or sellers get exhausted and it seems like they are taking some rest.
In the meanwhile, the opposite market participants look to gain control and try to drive prices in the opposite direction.
This is when the prevailing trend participants resume their activity and now the price is available at a discount to them.
This further intensifies their activity and the price resumes in its prevailing trend.
You should understand that price movement is all based on the demand and supply theory and every time one outweighs another, price moves in that direction.
Pros and cons of pullback trading
Suppose you have been tracking a currency pair for a long time and have identified a channel or a range being formed.
You decide to take a trade only if the price breakouts from the range and you wait for a confirmation.
The price breakouts out from the range but the candlestick is a very wide one. Would you take the entry?
You shouldn’t as your entry will be very bad and your RRR will be low too. Hence, you should wait for a pullback.
Now, pullbacks shouldn’t be traded just in such scenarios, it can also be used as a price confirmation tool.
For instance, price breaks out from a range, manages to breach the resistance. By basic theory, resistance would now become support.
If price pulls back to this level and it finds support and moves back up, it validates the trade.
Pullback trading has additional psychological advantages too as it allows traders to get prices at a discount.
Now coming to the cons side of pullback trading, pullbacks may never occur or even if the price approaches the level from where it broke out, it might just fall back into the range.
Traders often wait for pullbacks after breakouts, but it has happened a lot that price keeps moving in the direction of the breakout without any signs of a pullback.
If the trader simply traded the breakout here, they would have capitalized and wouldn’t have missed out on such moves.
Price, after a breakout, sees a pullback, what if this wasn’t actually a pullback and was a reversal?
By discussing all this, I don't intend to discourage you from trading pullbacks.
All I want to convey is that nothing is certain and pullback trading is no different.
It becomes very important that traders take these into consideration and have a plan in place that allows them to fully understand and capitalize on the price movements.
Types of pullbacks
Before I move on to teaching the techniques that I use to trade pullbacks, I want to first talk about certain types of pulbacks that I have observed in the markets.
I have classified these pullbacks into 3 types based on the extent till which the price pulls back or sees a correction and in order to guage this, we will use the Fibonacci retracement tool.
1. Short pullbacks
In a short pullback structure, the participants of the prevailing trend are in strong control and the price pullbacks in such conditions will be very short.
Here, the price will correct only uptill the 38.2% ratio of the Fibonacci retracement tool.
2. Medium pullbacks
In a medium pullback structure too the participants of the prevailing trend were strong but they have started facing a counter trend pressure.
In order to spot such pullbacks, you have to look for price retracement anywhere till the 38.2% or the 61.8% ratio of the Fibonacci retracement tool.
3. Deep pulbacks
In such conditions of deep pullbacks, the dominant participants are somewhat overpowered by the counter trend participants and the price moves well in the opposite direction.
Here, the price will correct till anywhere between the 61.8% ratio till the 0% ratio or from the point where the Fibonacci retracement tool was plotted.
It is in these type of pullbacks that majority of traders lose their money.
Now that you have understood the different types of pullbacks according to what i have experienced, let's explore the various methods by which I look to trade these pullbacks.
How to trade pullbacks?
Now that we have a good idea about pullbacks and know what pullback trading has to offer and what value it can add for traders, let’s explore some strategies or methods of pullback trading.
1. Swing high low pullbacks
Whenever price trends, it does not move in one direction in a straight line.
If you observe a trend, you will notice that it moves in a series of steps, this is also known as swing highs and lows.
For instance, if the price is in an uptrend, it creates a series of higher highs and higher lows. In a downtrend, it will create lower lows and lower highs.
Every time a higher high is created in an uptrend or a lower low is created in a downtrend, the price may see a correction.
Traders can take trades if the price pulls back to the previous higher high or previous lower low.
Stop loss can be placed at previous higher low in case of long trades and in case of short trades, it can be placed at previous lower high.
You can target the recent swing high or swing low from where the price pull backed or can have targets based on your RRR.
This method of pullback trading can be used to trade the short pullbacks that I mentioned above.
2. Trendline pullbacks
In order to trade pullbacks to trendlines, you first have to spot a trend. This trend could be both an uptrend and a downtrend.
Once a trend is spotted, you should wait for the price to move counter-trend.
After this counter-trend move takes place, look for a minimum of two price points to plot a trendline.
Wait for the counter-trend price move to pullback to the trendline and trades can be taken accordingly.
Trendlines are a very powerful tool in the arsenal of traders and if used properly, they can add a lot of value.
Do not blindly take a trade once the price pulls back to the trendline, you should have additional confirmation such as a candlestick pattern or a break of structure.
Once you see that price has stopped its counter-trend move and has now resumed moving in the prevailing trend, take a trade.
Stop loss will be placed at the previous swing high or low with a price buffer if you prefer.
Targets could be fixed according to RRR or you can even look to ride the trend entirely till it keeps respecting the trendline.
3. Moving average pullbacks
Moving averages are one of the best tools for identifying trends and in order to trade pullbacks, we need a trend in either direction.
Whenever price is trending, it will either be well above the moving average in case of an uptrend or it will be well below the moving average in case of a downtrend.
You can select any moving average of your choice but I would suggest having moving averages of a larger time period as it takes into consideration a larger price movement.
Once this is established, look for a price pullback towards the moving average, this will be a counter-trend move.
This is similar to the trendline pullback system.
After the price has pull backed to the moving average, look for confirmation of price resuming the prevailing trend.
Stop loss can be placed at previous swing high or low and targets could be fixed according to RRR or traders can look to ride the trend till the price is respecting the moving average.
You can use this method of moving average pullback trading to trade the medium pullbacks that I have mentioned above.
4. Fibonacci pullbacks
Fibonacci trading is very popular among forex traders and the majority of traders look to incorporate this in their trading.
There are many tools in Fibonacci trading but for the purpose of pullback trading, we will use the Fibonacci retracement tool.
In order to trade Fibonacci pullbacks, you again need to spot a trend in either direction.
Once a trend has been spotted, you need to plot the Fibonacci retracement clicking from the left to right.
In an uptrend, it will be plotted from the low to the high and in a downtrend, it will be plotted from high to low.
After the tool has been plotted, you will see some lines denoted with some ratios that include 38.2%, 50%, 61.8%, etc.
What you need to wait for now is a price pullback to these ratios.
Since there are multiple ratios, different traders will only look towards a particular ratio.
The most sought after ratio is the 61.8% and the 50% ratios.
Once price pulls back to these price levels, there will be some action that will be seen.
Again, we do not have to take trades blindly as price pulls back to these levels but rather we must wait for additional confirmation that the price is reacting to these levels.
Once this condition is satisfied, trades can be taken accordingly. Stop loss can be placed at the 38.2% ratio or the swing low or high. You can target the swing high or low or can have targets according to RRR.
Use this method to trade the medium pullbacks and you will be able to capitalize on any such price movements.
In order to trade the deep pullbacks, I normally use support and resistance zones and the Fibonacci retracement tool.
If the price retraces till the 0% level then I normally look to plot the Fibonacci again from the previous swing high or low level and then look for the price to retrace to the Fibonacci ratios of the newly plotted levels.
How to distinguish between pullbacks and reversals?
This is one thing that no one talks about and unfortunately a lot of traders lose money because they are unable to separate a pullback from a reversal.
In order to learn how to distinguish a pullback from a reversal, you first need to understand the concept of swing highs and low.
When price is in an uptrend, it creates a series of higher highs and higher lows. While in a downtrend, it creates a series of lower lows and lower highs.
These higher highs higher lows and lower lows lower highs are actually price pullbacks.
If you want to spot a reversal then you will have to see if price breaches the previous swing low in an uptrend or the previous swing high in the downtrend.
If this happens then you will get an indication that the trend has reversed and that the counter trend participants have gained strength in the market.
Using this technique will allow you to trade pullbacks efficiently and protect your capital from losses that would be incurred in losing trades.
When will you start trading pullbacks?
This blog post has everything you need to know about pullback trading and you can apply the concepts discussed in this to begin pullback trading right away.
Do let me know about your experience with pullback trading and whether this blog post was helpful.
Share this blog post with every trader you know and let them also explore this style of trading.
Shoot all your questions or queries in the comments section and I will get back to it at the earliest.