11/04/2010

How to develop pullback method


This is a never ending debate and a subject which is constantly argued about by traders and everyday I get emails from members asking how can  they buy pullbacks before the breakout. There is almost an obsession for some people, they want to be in stock before breakout.

Ed Seykota was asked this question in a seminar and his reply was (I am paraphrasing his words)

"Traders who  buy on pullbacks may miss some major movers that don't pullback and are sure to be in  all the moves  that fail to follow through. Buying pullback ensures you will be in most reversal moves."

In the stock market you can buy breakouts and make money. You can also make money buying pullbacks. There are hundreds of breakout based methods in public domain on both side.  If you are interested in buying pullbacks then look at the RSI2 method which I have shared before. It buys pullbacks. 

As a general observation after studying the markets for last 12 years or so and especially studying stocks which go up 100% plus in a year or 25% plus in a month, I can tell you that if you are primarily a pullback trader you will miss out on some of the best opportunities in the market.

But because market is so vast and you have 10000 stocks to play with there are also enough pullback opportunities. It is not very difficult to develop pullback methods. The most commonly used approach to developing pullback methods are:
  1. Buy first pullback after a major breakout. You can define major breakout in many ways like say a multi month  trend line , or breakout above channel, or breakout above 200 day moving average or a breakout of 25% or more from a 52 week low, or any such major milestone.
  2. Buy first pullback to 50 day moving average. This is like most commonly used swing trading method. Some time back I studied the most popular swing trading courses and most rehash this same concept again and again. Same soda different bottle and different color. 50 ma becomes 20 MA or 39 MA or some other MA.
  3. Buy double bottom at top of the range on trending stock. Again this is extremely popular method. You find a trending stock on longer time frame that has in recent days gone in to range. You buy a double bottom pattern in that range. These kind of methods work well on high float stocks and stocks with high liquidity. Especially well on stocks in S&P 500 and Nasdaq 100. The Curtis Faith setup which I shared  sometime back is a good example of that kind of setup. IBD also talks about this setup as one of the bases to look for in leading stocks. Typically you should not try and trade these kind of setups on small cap stock. In most small caps there is one big rally and then they exhaust themselves. Buying such pullbacks on most of them would make you a bag holder. Such setups work well on established stocks where there is lot of fund support. The funds like buying dips so the setup works. For small cap most of the time it is one rally and end of story. 
  4. Retracements to Fib levels is another very popular pullback buy techniques and if you just run a search you will find over 1000 such swing trading setups. 
  5. Retracements to 10 or 20 day lows. This is another very popular method for buying pullbacks and again tends to work on bigger stocks.
  6. Retracement to ATR channel is another commonly used pullback method. 
  7. Oscillator based pullbacks. There is a vast array of oscillator based methods. Most traders have some sort of oscillator like Stochastics on their charts and such pullback methods are very popular. If you go to the Wealthlab archives you will see examples after examples of pullback based systems that have performed well in backtesting.

The key to trading pullback again boils down to selecting the right kind of stocks to trade pullbacks on. Some stocks like momentum stocks or growth stocks are best traded using breakout methods. Because they are very prone to sudden burst of momentum phases which can go vertical without any pullbacks. 


See these three stocks:

By the time you get first pullback the move might be over. You can hope for a pullback but the stock is not obliged to offer you that low risk buying opportunity. That is the nature of small caps and stocks with above average momentum. 

As against that look at these stocks:

These kind of stocks will give you nice pullback buy opportunities. Because the trading dynamics behind them is very different. These are large mature businesses that have large fund holding and everytime they dip below a certain level buyers step in. that is why if you study carefully the hundreds of pullback systems which have shown to be performing well in backtest, they typically use S&P 500 or Nasdaq 100 as their universe. Same way if you want to trade say the S&P mini or Nasdaq mini or any YM mini you will see pullback based methods work best. Both pullback based and exhaustion based methods tend to do well on established markets. They also tend to do well in range bound markets and may not do well in bull markets or highly trending markets.

If you want to develop pullback based method then you need to work at it for months and trade it in live and then perfect them. For me breakouts work and I spend my time and energy on breakouts. I have cumulative 12 years and thousands of trade experience of trading breakouts and I have done very well using them so I stick to them.

One of the key points Mark Minervini emphasized in his seminar was to find a method that suits you and then perfect it by going in to microscopic details on it. He gave an example of Warren Buffett and Bill Gates. Saying both are very good friends , then why Buffet has not bought Microsoft shares. Because his expertize is value investing and he sticks to it. He has significant edge in doing whast he does. He does not go around becoming a growth investor or CANSLIM investor next.

Recently I was reading a book on hedge fund managers. They were all leading hedge fund managers and some of them suffered big losses in 2008, and they were asked what was one of the biggest mistake they did and most said that their big mistake was to trade too many strategies. They said that when they started their hedge fund they had core set of strategies they traded and were very successful with them for years. But then they got in to the game of becoming multi strategy hedge funds trading different markets and strategies and then they lost their edge  and their core goal after 2008 debacle was to gt back to their core strategies. 

As against that most novice want to trade a bunch of styles. They want to be day trader, Cramer followers, growth investors, turnaround traders, macro traders, quant traders, value traders, options traders, futures traders  and whatever else they might hear of next. They want to trade pullbacks, breakouts, exhaustions and in doing so they are too exhausted. It does not work so they go from one site to another site, from this book to that book, from this newsletter to that newsletter and in the process blow up their account.

As against look at people like Minervini , he trades one method and has been at it for 15 years. It took him 10 years to develop and fine tune that method. Look at Dan Zanger he trades very simple breakout method and he has perfected it over many years. Before doing that he blew up 3 times. Look at any other traders who has survived the learning curve and prospered for 10 years and you will see that they trade very few setups but on that setup they have extensive experience.

Why is this focus on setup important. There is very good reason for it. Because your brain works in certain manner when it comes to developing procedural memory. If you try and beat the rules of how procedural memory works you will never succeed. Procedural memory is extremely task specific. It is built as a mechanism to overcome cognitive load. It allows you to perform a task efficiently once developed. Once you develop one procedural memory and then attempt next thing , the mind can handle it. That is why setup selection is key. You select a setup and develop a procedural memory to trade it. That is how you become good at it.

Trading psychology is about understanding how your brain and mind works and manipulating it to become profitable trader. It is extremely important to understand procedural memory and how it works and how it is developed if you want to be successful and profitable trader. 

And if you study procedural memory you will realise how you are daily self sabotaging your own procedural memory  development.




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