I have found, over the years, solid results from trading a handful of patterns put in the proper context. Perhaps the most useful of those patterns in the pullback, which is simply a pause in an ongoing trend.
Of course, how well you do trading pullbacks will depend on a number of factors. One of the most important of those is evaluating the trend in which the pullback occurs. It’s obvious after the fact (though harder in real time), but strong trends will lead to better trades in the direction of that trend.
But the question is how to evaluate that trend strength when we put on the trade, at a time when the market has been moving against (“pulling back”) against that trend direction.
A recent trade in NYSE:IP gives us some good lessons.
One of the best ways to identify a strong trend is to find a new trend that occurs after the termination of a previous trend. In this case, the weekly chart shows a long-term uptrend that had gone on for more than a year.
At A) the daily chart shows some signs of a buying climax: a large move above the upper Keltner (following a “slide along the bands” advance), a quick candle reversal pattern at the top, and then a stunning selloff into B).
From that point, there are a number of bear flags (marked with trendlines) that break down as the stock trades lower.
We can also see that this is not a “clean” trading stock: many gaps, many days with small ranges and low volatility, and generally unclear patterns. We need to know this because this will have an impact on how we get into trades, and how we manage those trades.
The arrow shows the date on which we added this stock to Adam’s List (a curated list of the best setups I see in the market, and that I share with my clients at MarketLife).
There are several ways to enter this trade, and this podcast will give you some ideas, but now our attention shifts to trade management. We can assess the overall market environment (perhaps set for a rally reversal, but also with good potential for a large decline—it’s possible to justify a move in either direction from the current point.)
A plan of tightening stops aggressively (but, of course, this can be overdone) and taking profits at initial targets is generally the solution to managing these kinds of trades, but this can be adapted to your own trading style and risk tolerance.
There’s a lot to extract from this lesson, but here are the important points:
- You can build an entire trading plan on trading pullbacks.
- Putting the simple pattern in context of the overall trend and market can make that pattern even more powerful.
- Trend exhaustion followed by strong countertrend momentum can lead to good moves and strong trend change.
- Trade management matters, probably more than trade entry.