I’ve written quite a bit lately on things that don’t work, and tried to point out some errors in common practical technical analysis. Yes, I’ll do more of that in the future (I suppose perhaps because I am a curmudgeonly soul (and, really, how often do we get to use that word?!)) But, today, I want to share with you a very simple, concise pattern that has a tremendous statistical edge. This pattern has been one of the mainstays of my trading techniques for many years. Daytrading, position trading, even looking at relative performance of sectors, trading options, trading spreads, outrights–this is a pattern that can inform all of your tactical/technical trading in the marketplace.
A pullback seeks to capitalize on the fundamental principle of trend movement: trends don’t move in straight lines. Rather, they move in periods of with-trend strength, interspersed with consolidations and pullbacks. Now, I think a lot of nonsense has been written about this–about patterns and types of pullbacks, and ratios, and different expectations based on these distinctions. (Maybe I’m wrong and it is not nonsense. I still continue to do research in this area.) I’m happy to tell you that you don’t need any of that stuff; all you need is to understand this fundamental pattern of the market, have some way to identify when a market makes a “strong thrust”, and then have some trade management skills with respect to stops and targets. (Well, you also need to be well capitalized, size positions correctly, and do everything with perfect discipline. This isn’t easy!)
The chart above is from the portion of my book I decided not to publish, and shows one way we can define pullbacks. In this case, once a market goes to a channel (any channel, within reason), you can look to enter around the moving average. Yes, there’s a lot of imprecision in that statement, because it all works. The concept here, of working within the fluctuations of the market, is solid and works across a wide range of markets.
The table above can be a little bit hard to read at first, but it’s worth a few minutes of your time. I’ll shortcut it for you: it shows a strong edge for both buys and sells across stocks, futures, and forex, and it’s one of the very few patterns that shows this kind of clear edge. No, it’s not a huge edge, but, as I’ve written before, markets are competitive; there are no huge edges. There are no statistical homeruns. There are, however, small, robust edges that we can apply, with perfect discipline, and pull superior risk-adjusted returns out of the market.
I also want to do something a little different today. Self-promotion really is foreign to me, as my long-time readers have seen. I suppose that’s because of my experience as a trader–seeing that every single time I have gotten overconfident the market has reminded me to be humble. I’m never going to be that guy telling you what “has to happen” with a stock or any market (because I think “that guy” is being intellectually dishonest, too.) However, in my published research, we are going through a period of really solid performance: we’re short the euro, short the pound, short soybeans, and have on a few other trades that are doing reasonably well. Clients get a lot of detail on the trades, specific entry levels, stop losses, profit targets, and ongoing trade management commentary. (Ahem, here’s my forced self-promotion note: if you’re interested, we do offer a free trial. Use this form to contact us. (Also, because I’m a cynic, I probably just nailed in the high or low on some of those markets by making this post!))
(Edit: my work is now available at Talon Advisors.)
The point here is that each of these trades was based on a pullback on the timeframe shown: the same simple, robust pattern over and over. I’m reproducing current charts with an arrow marking the entry so you can see how these patterns played out. (In all cases, the entry was on the next bar of the chart following the arrow.) Yes, there’s subtlety and an element of discretion here–some finesse even–and trade management is essential. Regardless, you can base an entire trading program on this simple, robust pattern that works.
This Post Has 19 Comments
Adam, what I don’t understand is how such an obvious pattern like the pullback sustains for decades, especially in our times of more and more sophisticated algos. I have read some articles about momentum which often correlates with pullbacks and the authors mainly write that momentum has been such a consistent factor because it is rooted in our behavioral biases and that news takes time to be fully priced in. But this should change with a market becoming more and more traded by algos. Btw, I gained the impression that in the last weeks/months a lot has been published about momentum which might also be a harbinger for a shrinking edge regarding momentum strategies.
What do you think, why has been momentum and the pullback pattern so robust in the market?
The algos focus more on the intraday timeframe. Their trades (along with the trades of humans) are the ones causing the “noise” in the price action. I am not putting blame here, just stating the fact which has been true even from the early days of financial markets.
So given the above info, we need not worry about algos. One way to avoid them is to trade in a higher timeframe. I have found trading on the weekly timeframe to be cleaner/clearer from noise. The chart below shows a current trade in EPI (India ETF). Notice how EPI made a strong thrust to break the red downtrend. Then it consolidated (pullback) in the white area. A position was initiated on a breakout from the white consolidation area (also marked by the green arrow). The first profit target was reached at the yellow arrow. Then notice another consolidation area (pullback) designated by the blue area and EPI breaking out from it. Will EPI move to higher prices? We’ll see. The stop has been raised to the blue arrow to lock in more gains.
Instead of focusing on algos, I simply focus on finding clarity on the balance of buying and selling pressure. A pullback is a market structure that provides clues to that.
It can be argued that there might not be much algos in EPI.
Let’s take a look at MSFT. It’s pretty popular and I guess it’s safe to assume there are a lot of algos in there.
The chart below is on the weekly timeframe (see my comment above on why it will help reduce the noise). Notice the pullback indicated by the white line. A position was initiated on a breakout from the white pullback (also indicated by the green arrow). Notice how it started to move up from then on.
thanks for your response. I am trading pullbacks intraday on a 5M and 15M timeframe and it works if you use appropiate SLs and targets. As you do I suppose there are more algos trading on the short and ultra-short timeframes. If you want to trade pullbacks you need instruments with a wide enough daily ATR and therefore I would currently not trade the T-Note futures.
But my question is why it works so well, not only the pullback pattern, but also momentum. The edge should get smaller if those trades become more crowded or it might vanish if the market gets more efficient.
On the other hand, imagine good new hits the mkt and a stock rises. It cannot get his new “fair” value in an instant cause there are funds who have to buy 100ks of shares and they have to do it step by step. Buying, selling a bit to release some buying pressure from the mkt and so on. Perhaps this is the reason why momentum has been so persistent.
Good stuff, guys. Thank you both for thoughtful discussion and good questions.
You actually got your own entire post here: https://adamhgrimes.com/reader-question-patterns-work/
In general do you tend to mange pullbacks in futures and currencies differently than if you were trading a pullback in a stock? For example would you tighten stops quicker once a stock has moved in your favour playing for one clean swing with little giveback compared to a future or currency where you might be looking to hold for an extended trend?
The not-very-helpful answer is “it depends.” what it depends on is not so much asset class as overall situation and market environment. In other words, there are times I will tighten very aggressively and times that I will give things more room. In general, I tend to give pullbacks wider stops than some other trades, but it does depend…
Thanks, that’s understandable and makes sense. I’m trying to develop my own profit taking rules and have found your trade review videos very helpful.
Amazing article. Thank you.
The point I am trying to understand is how do you program “it depends” in Stop levels or profit targets in order to verify if the system has a statistically significant expectancy? Currently, I am using ATR based stop loss and bollinger bands based profit targets but would be grateful for any guidance on better way of defining it
Well, you have to make some decisions, and then realize you are testing those decisions. You also need to be careful about refining those decisions, because this can lead to overfitting the question to the data.
I think the details of this can be worked out in many ways. Compare Keltners to Bollingers in your test, perhaps?
Adam, is it safe to assume that the results in the chart above are only for entries in which a bar touched the 20 EMA? I understand there is a great degree of discretion in what I am about to type, but many times price comes close (but does not touch) the 20 EMA during the pullback. Just wondering if you took entries only if the 20 EMA was touched in the above sample, as I am not sure what Keltner Pullback Entry on “Previous Bar’s EMA” means… Thanks.
Correct… the previous bar’s EMA was the entry for this test.
from my experience 10, 25 and 200 EMA give most precise ‘touch’ points to use for entries and exits ;;; additionally apply pivot points (daily/weekly/monthly) and see which levels correspond to ema ;;; Good Luck !
My work contradicts this. There is nothing special about any moving average (nor the pivot points)… what matters is the concept much more than a precise ‘touch’ point. Any average will work–prove to yourself that the 20, for instance, is better than the 24… if you can do the statistical tests that’s not a hard test, but if you do it subjectively by hand just make sure to keep good records. Also, I’d take a good, hard look at your pivot points and ask if they are better than random levels. This is very important if we are to understand how the market really moves and where our trading edge really comes from.
I feel the benefits of the ema’s ,sma’s all of it is because they are being watched by so many people that all share similar psychological mannerisms. We as a crowd make the price move and as our ability to analyze and see the price action with less and less delay, our effect becomes exponentially more rapid. It’s kinda like those oijia(sp?) boards the collective group moves the pieces… and those pieces don’t have indicators that are giving hints as to where we should go next. We make it easier on ourselves, but all the algo’s, news, emotions and different type market participants and manipulation have price in a constant state correcting always trying to get on the same page with price action together, but rarely able to ever pull it off for any length of time, and when we do everyon see’s it and there goes craziness again due to emotions
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