What is a Pullback?
A pullback is a pause or moderate drop in a stock or commodities pricing chart from recent peaks that occur within a continuing uptrend. A pullback is very similar to retracement or consolidation, and the terms are sometimes used interchangeably. The term pullback is usually applied to pricing drops that are relatively short in duration—for example, a few consecutive sessions—before the uptrend resumes.
- A pullback is a temporary reversal in the upside price action of an asset or security.
- The duration of a pullback is usually only a few consecutive sessions. A longer pause before the uptrend resumes is generally referred to as consolidation.
- Pullbacks can provide an entry point for traders looking to enter a position when other technical indicators remain bullish.
- Traders can use limit orders or stop entry orders to take advantage of a pullback to get in on the primary uptrend.
What Does a Pullback Tell You?
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 with existing positions take the profit off the table, i.e., selling some or all of their long positions. The positive earnings, however, are a fundamental signal that suggests that the stock will resume its uptrend.
Most pullbacks involve a security’s price moving down to an area of technical support, such as a moving average, pivot point, or Fibonacci retracement level before resuming the uptrend. Traders should carefully watch these key areas of support because a breakdown from them could signal a reversal rather than simply a pullback.
Example of How to Use a Pullback
Pullbacks typically don’t change the underlying fundamental narrative that is driving the price action on a chart. 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 20%. The stock may experience a pullback the next day as short-term traders lock in profits by selling some of their long positions. However, the strong earnings report suggests that the business underlying the stock is doing something right. Buy-and-hold traders and investors will likely be attracted to the stock by the strong earnings reports, supporting a sustained uptrend in the near 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.
The Difference Between a Reversal and a Pullback
Pullbacks and reversals both involve a security moving off its highs, but pullbacks are temporary and reversals are longer-term. So how can traders distinguish between the two? Most reversals involve some change in a security’s underlying fundamentals that force the market to re-evaluate its worth. For example, a company may report disastrous earnings that make investors recalculate a stock’s net present value. Similarly, it could be a negative settlement, a new competitor releasing a product or some other event that will have a long-term impact on the company underlying the stock.
These events, while happening outside the chart, so to speak, will appear over several sessions and initially will seem much like a pullback.
Traders use moving averages, trendlines, and trading bands to flag when a pullback keeps going and is at risk of entering reversal territory.
Limitations in Trading Pullbacks
The biggest limitation of trading pullbacks is that a pullback could be the start of a true reversal. Being that both pullbacks and reversals happen on a range of timeframes, including intraday if you want to go granular, one trader's multisession pullback is actually a reversal for a day trader looking at the same chart. If the price action breaks the trendline for your time frame, then you may be looking at a reversal rather than a pullback.
In this case, it is not the time to enter a bullish position. Of course, adding other technical indicators and fundamental data scans to the mix will increase a trader's confidence in distinguishing pullbacks from true reversals.
How Can I Tell if a Decline in an Uptrend is Just a Pullback or Something More?
The first place to look is at the fundamental story behind the uptrend. Has fresh, negative news hit the particular security and precipitated the pullback? Or is the pullback part of an overall, general market decline (e.g., Wall Street had a bad day)? You can also monitor key technical support levels to see if they hold. In case they fail, you might be looking at a more significant correction or even a reversal.
How Can Traders Take Advantage of a Pullback to Enter at a Cheaper Level?
First, look at the fundamental story underpinning the uptrend. If nothing serious in the way of bad news has hit the security, you're likely looking at just a mild pullback. In this case, traders can use a variety of orders to establish long positions at relatively cheaper levels. Traders can enter immediately with a buy market order or wait for lower levels with a limit buy order. In case the pullback ends and prices begin to move higher, traders can use a stop buy entry order at a level above the current market.
How Can I Tell if an Uptrend is Ending or Simply Undergoing a Pullback?
Double-check to make sure nothing has changed in the fundamental picture of the underlying security. Next, take a look at trend and momentum indicators (e.g., relative strength index or RSI, average directional index or ADX, moving average convergence divergence, or MACD) to see if they're turning lower, potentially signaling a more significant decline is at hand. If either of these conditions is met, take a step back and consider whether the uptrend has hit a significant high and tighten up your stop-loss sell order to minimize potential further losses.
The Bottom Line
Pullbacks are a normal part of any sustained uptrend. They can be triggered by profit-taking after a sudden surge higher in the price of a security, or some minor negative news about the underlying security. Trend-following traders frequently use pullbacks to get in on the dominant uptrend, or to add to existing longs. They can do this through buy limit orders, stop buy entry orders, or just a plain market order if they want to jump right in.
Pullbacks usually stabilize or find a near-term bottom at consequential technical levels, such as a daily moving average, a bollinger band, or a Fibonacci retracement, to name just a few technical support levels. It is important to note that if these support levels fail, you may be looking at a bigger correction, or even a total reversal.
Traders should look at other indicators, such as momentum oscillators like the RSI, to see if there are any bearish divergences that may signal a deeper correction. But if the fundamental picture for a company or currency has not changed significantly, it increases the likelihood that it's just a normal pullback that should stabilize over a few sessions, and offer buyers a chance to get in on the primary uptrend at a cheaper price.