A pullback is the falling back of a security’s price from its peak. These price movements might be seen as a brief reversal of the prevailing trend higher, signaling a temporary pause in upward momentum. Also referred to as a retracement or consolidation.
Pullbacks are widely seen as buying opportunities after a security has experienced a large upward price movement. For example, a stock may experience a significant rise following a positive earnings announcement and then experience a pullback as traders take profit off the table. The positive earnings, however, suggests that the stock will resume its uptrend.
Most pullbacks involve a security’s price moving to an area of technical support, such as a moving average or pivot point, before resuming their uptrend. Traders should carefully watch these key areas of support since a breakdown from them could signal a reversal rather than a pullback.
Pullback and reversals both involve a security moving off of its highs, but pullbacks are temporary and reversals are longer term.
How do you distinguish the two?
Most reversals involve some change in a security’s underlying fundamentals that force the market to reevaluate its value. For example, a company may report disastrous earnings that make investors recalculate a stock’s net present value. In the futures market, a downturn in automotive demand could lead to lower demand for steel and other commodities, which would be expected to continue over a long period of time.
In contrast, pullbacks typically don’t change the underlying fundamental narrative. They are usually profit-taking opportunities following a strong run-up in a security’s price. For example, a company may report blow-out earnings and see shares jump 50%. The stock may experience a pullback the next day as short-term traders lock in profits. But the strong earnings report suggests that the stock is still headed higher over the long-term.
Every stock chart has examples of pullbacks within the context of a prolonged uptrend. While these pullbacks are easy to spot in retrospect, they can be harder to assess for investors holding a security that’s losing value.
In the example above, the SPDR S&P 500 ETF (SPY) experiences four pullbacks within the context of a prolonged trend higher. These pullbacks typically involved a move to near the 50-day moving average where there was technical support before a rebound higher. Traders should be sure to use several different technical indicators when assessing pullbacks to ensure that they don’t turn into longer-term reversals.
Pullbacks are widely seen as buying opportunities after a security has experienced a large upward price movement. They shouldn’t be confused with reversals, which tend to be longer term downtrends where there has been a change in fundamentals. Traders should be sure to use technical analysis to verify that a pullback remains above key support levels to avoid possible longer term reversals that could result in losses.