Trading Persistent Pullbacks
By Dave Landry
“One should not increase, beyond what is necessary, the number of entities required to explain anything.” – Occam’s Razor
“Simplicity is the ultimate sophistication.” – Leonardo Davinci
In Was Right In Front Of Me All Along
I spent many years searching for the perfect methodology. I would wake up early and stay up late knowing that if I worked hard enough, I would find it. I have tried every indicator that I could get my hands on. I went through numerous texts on technical analysis and spent many hours studying each and every indictor, oscillator, moving average convergence divergence, stochastics, Fourier Transforms, Relative Strength Index, and cycles. You name it, I tried it. Not only did I study these indicators carefully but I would even create new indicators from the indictors, making the complex even more complex. I have even studied arcane methods such as counting price bars and price waves. I was obsessed.
It took me many years to come to the realization that there is no holy grail — no method that will lead to eternal profits while avoiding all losses. More importantly, I learned that simple is better. Since the ultimate goal was to capture a price trend, I began to think I should focus on that. So I did. Little by little I began peeling away the indicators and focused more on price, seeking out trend. I reached a point where I was back to a blank chart. In fact, other than the occasional moving average, I do not use any indicators.
Although not perfect, I discovered that the best way to enter a trend was after a correction, also known as a pullback. While studying trends, I found that those markets in the most persistent trends had the greatest chances of resuming that trend after the next pullback. This is how Persistent Pullbacks became one of my favorite patterns.
In spite of their simplicity, they can be very powerful and effective. They keep you on the right side of the market during trending periods and out of the market during less-than-ideal conditions.
Let’s break it down.
Persistency is simply a market’s ability to follow through from one day to the next. This is illustrated below. For those more mathematically inclined, this can be measured by complex methods such as linear regression. However, for the rest of us, we can simply look at the chart and draw a trendline through as many bars as possible.
An advantage of the Persistent Pullback pattern is that it self regulates. This is especially true if you also require sector confirmation, which I highly recommend. In choppy markets, it is virtually impossible to find any stocks set up as persistent pullbacks. In bull markets, it is virtually impossible to find shorts. And in bear markets, it is virtually impossible to find longs. In fact, I studied thousands of charts from the slide that began in 2007 to the March lows of 2009. I could not find any buy side examples during this period. Further, both long and short side setups were very few and far between during the trendless market of 2011.
This self regulating nature can be great for those new to trend trading. It keeps them on the right side of the market. And it keeps them out of the market during less than ideal (e.g. choppy) conditions. This is why I suggest that those new to trend trading only trade persistent pullbacks until they gain confidence.
More experienced traders will find persistent pullbacks very useful when they find themselves fighting trends and overtrading during choppy markets. During these difficult times, I suggest that they return to trading only this pattern. This will put them back on the right side of the market and will keep them out during choppy conditions. In fact, on more than one occasion, I have suggested traders in a slump to do just that. Alternatively, when you find yourself having difficulties, you can pay me a lot of money to work one-on-one with you. Or, you could just exclusively trade Persistent Pullbacks until you regain your confidence.
Now, let’s look at the rules for the pattern. This setup was originally published in my second book Dave Landry’s 10 Best Swing Trading Patterns and Strategies and is also in latest book: The Layman’s Guide To Trading Stocks.
1) The stock should have moved one month, approximately 20 bars, in one direction. Ideally, a trend line drawn through the bars should intersect as many bars as possible. This can be done by hand or by using a linear regression trendline. During this period, the stock should have had made a significant move.
2) After Rule 1 has been satisfied, look to enter on a pullback or pullback related pattern. One of my favorite patterns that often occurs out of a persistent move is a Trend Knockout (TKO). A TKO is simply a market in a strong trend that has a “knockout” bar—it makes a new 2 bar (at least) low on an expansion of range. This helps to shake out the weak hands and attracts eager shorts. Both can help clear the way for the stock (or other market) to trade higher. See the aforementioned books for more on this pattern.
Now, let’s look at some examples.
1) Global Industries was in a sharp, persistent uptrend.
2) The stock has a sharp one day pullback, forming a TKO.
3) Enter as the high of the knockout bar is taken out.
4) The trend resumes, gaining over 18 percent in the next 2 weeks.
1) Sears Holding Corp. is in a solid, persistent downtrend.
2) The stock pulls back.
3) Enter as the trend resumes.
4) The stock resumes its slide, losing over half of its value over the next few weeks.
At the time this article was being submitted for publication (March 2012), the major indices set up and were rallying out of Persistent Pullback Patterns.
1) The Nasdaq Composite Index was in a persist uptrend. Notice the line through most of the bars. Also notice that those the line does not intersect are above the trend line. This is a sign of further strength.
2) The index pulls back.
3) Enter as the trend resumes.
4) The Nasdaq rallies nicely out of this pattern.
Ready, Set, Wait
Before jumping in, make sure you fully understand the pattern you’re going to trade. Study it in good conditions and more importantly, study it in less-than-ideal conditions. Then, paper trade it for a while until you get comfortable with it. This will give you a feel for things both good and bad. Further, without real money on the line, it’ll be easy to follow your plan. This brings us to our next point. I’ve never met an unsuccessful paper trader.
Once real money is on the line, trading psychology becomes very important. You have to know the pattern inside and out and more importantly, know yourself. You have plan your trade and trade you plan. This is much easier said than done. You will have to know where you will get in, place your protective stop, how you will trail your stop, and where you will take partial profits. As I preach, obsess before you get into a trade, not afterwards. Trading is much easier if the majority of the decisions are made ahead of time instead of during the heat of battle.
It’s beyond the scope of this article to get into a complete game plan for trading, but there are a few things you should know. Below is what I call my “Methodology In A Nutshell” figure. If you understand this figure, you understand the basics of my methodology. The rest is just details.
For those interested in more details, refer to the background information at the end of this article.
Persistent pullbacks are a very simple, very effective pattern. They are self regulating. You get more setups in good times and fewer setups in bad. This is especially true if you require the sector and the overall market to also be in a trend. Ideally these would also be characterized as a persistent trend.
Persistent pullback’s self regulating nature helps keep traders on track. When discipline breaks down, persistent pullbacks force us to stick with the trends instead of fighting them. Most importantly, the pattern will keep us out of the market when it is trendless.
The pattern works equally well on the long and short side of the markets. However, because they “slide faster than they glide,” you are more likely to find orderly persistent uptrends than downtrends. The best trades occur when the sector and overall market are also in persistent trends.
About The Author
Dave Landry has been have been actively trading the markets since the early 90s. In 1995 he founded Sentive Trading, LLC, (d/ b/a www.davelandry.com)–a trading and consulting firm. He is author of Dave Landry on Swing Trading (2000), Dave Landry’s 10 Best Swing Trading Patterns & Strategies (2003), and The Layman’s Guide to Trading Stocks (2010). His books have been translated into Russian, Italian, French, Japanese, Chinese, and Korean. He has made several television appearances, has written articles for several publications including Technical Analysis of Stocks & Commodities, Active Trader, Currency Trader, and Traders Journal-Singapore. He has been publishing daily web based commentary on technical trading since 1997. He has spoken at trading conferences both nationally and internationally. He holds a Bachelor of Science in Computer Science and has an MBA. He was registered Commodity Trading Advisor (CTA) from 1995 to 2009. He is a member of the American Association of Professional Technical Analysts.
Background Information: Trading Pullbacks In Trending Markets–Some Details
Obviously, all of the details about trading pullbacks cannot be covered in this article. Entire texts have been dedicated to the subject—I have written three. However, if you understand the following crucial concepts, then you will understand the crux of my approach. Referring back to the “Methodology In A Nutshell” graphic:
a. Trend: Trend is the key word in the title of this section. It’s the most important thing. If markets are not trending then they should be ignored. And, ideally, for equities, the corresponding sector/other stocks within the sector and the overall market should also be trending.
Markets don’t always trend, so there will be times where there is no action to be taken. This can create performance anxiety for the individual trader looking for income or the fund manager who is under pressure to produce results. Although it’s beyond the scope of this article, I would be remiss if I didn’t mention the psychological aspects of being patient. For a trending methodology, the trader must be able to sit through extended sideways markets and resist the temptation to try to make something happen where no opportunities exist.
b. Correction: For uptrends, the market must correct by moving to oversold. “Oversold” is a relative term based on the market’s previously measured volatility. A volatile market will have to pullback significantly to become oversold. Conversely, a low-volatility market can pull back must less percentage wise but still be considered oversold.
c. Entry: The trade is taken if, and only if, the trend shows signs of resuming. If it does not, the trade is avoided. This helps to avoid losing trades based on false moves. The further the entry is away from the current market price, the less likely it will trigger and more false moves will be avoided. In trading though, there is always a tradeoff. Higher entries give up more of the reversion to the mean move (i.e. the move from the oversold pullback back to the old highs). Further, if the longer-term trend does not resume, it’s possible that an entry too far away from the current price would trigger just as the reversion to the mean exhausts itself.
d. The protective stop. No matter how great a potential trade may look, there’s always the potential that it might not work. Therefore, a protective stop is always used. Based on the volatility of the underlying instrument, the stop is placed far enough away to avoid the normal noise of the market in an attempt to ride out a short-term “swing” type move as the market reverts back to its mean.
e. Partial profits (half) are taken when the profits on the initial trade are equal to (or exceed) the initial risk.
f. The stop is then trailed higher as the position moves in our favor. Initially, the stop is trailed fairly tightly–usually on a one for one basis—to keep risks relatively low. Once the market has proven itself by hitting the initial profit target, the stop is then gradually loosened to hopefully ride out a longer-term winner.
Understanding this transitioning of the trailing stop from a short-term tight stop to a longer-term looser stop is crucial. It’s what allows you to capture the occasional “homeruns.” Without these, returns would be mediocre at best.
Dave can be reached at email@example.com