Trading Stock Market Pullbacks

Trading Stock Market Pullbacks

Trading Stock Market Pullbacks can feel like jumping off a cliff…

Trading Stock Market Pullbacks isn’t easy. But understanding how to navigate pullbacks in the stock market, as well as in your favourite stocks, is important to your trading success. And given yesterday’s stock market pullback it’s worth discussing this critical concept a little more. Why?

Trading stock market pullbacks is one of the most volatile and emotionally difficult aspects of investing. How do you know when you should double down and invest more, or cut your losses and move on? In this blog post we’ll look at some of the easiest ways to trade through a stock market pullback.

And the first thing you should know is that not all pullbacks are created equal…

Trading Low Volume Stock Market Pullbacks:

When you’re trading stock market pullbacks one of the most important things to keep an eye on is trading volume. That’s because trading volume can give you insight into the nature of the pullback. For example…

A light (or low-volume) stock market pullback happens when the selling volume on the pullback is significantly lower than the buying volume was on the way up. You can easily see this on any stock chart. And a low volume stock market pullback might indicate the stock is just consolidating recent gains. Ideally you would like to see a shallow pullback with a tighter trading range before making your next trade.

On the other hand:

A vicious high volume pullback might indicate a changing of sentiment about your stock of choice or the stock market as a whole. So you should be especially careful if the price advance was on low volume and the pullback in your stock is happening at very high volume. This indicates that a lot of people are selling the stock. At this point, you would probably want to wait until your stock pulls back to a recent support level and wait for it to find stability before buying more.

Erring on the side of caution in trading a stock market pullback can go a long way to protecting your capital and keeping you out of trouble so you can live to trade another day. One more trick you can use to improve the way you trade stock market pullbacks is to look at how the stock market as a whole is trading…

Trading “Top Down” Stock Market Pullbacks:

Trading stock market pullbacks can be difficult because you never know for sure if your stock is in a mild consolidation or a nasty multiple compression. One way you can get some more context on the character of your stock pullback is to consider how your stocks are trading relative to the rest of the market.

Jesse Livermore’s book How to Trade in Stocks first introduced me to the idea of “top down trading.” The basic premise is that the market moves in a convoy and you can improve your chances of success by following the trend of the majority. If the majority of stocks are pulling back you may want to be careful. But if similar stocks are improving maybe the stars have aligned and your pullback presents a low-risk entry opportunity.

As an example:

If you’re trading a local bank stock that is pulling back, you want to look at what the other banks are doing to gauge the nature of the pullback in your stock. You can look at the regional bank ETF (KRE) to get an idea of how the sector is doing. Then you can look at the financial ETF (XLF) to see how all the financial services industry as a whole are doing. And finally you can look at the S&P-500 to see how it’s acting. When you use these other stocks and markets as indicators you can get insight into the nature of the pullback and whether or not you should buy more stocks.

And while these volume and breadth indicators are useful, trading stock market pullbacks isn’t just about technical analysis

Fundamentals of Trading Stock Market Pullbacks:

Trading stock market pullbacks is not only about technical analysis. Especially in the case of high volume stock market pullbacks it’s important for you to re-check the fundamental thesis of your stock idea

Checking the fundamentals of your stock during a market pullback is easy to do and can save you a lot of pain. Just pull up a quote of your stock on Google Finance, Stocktwits, Seeking Alpha and even the Yahoo Finance message boards to see if any news has been published that might materially change the fundamentals of a company. For example…

Maybe the company has announced a cut to the dividend, an unexpected loss from operations or an expensive write-off that investors weren’t expecting. In any case, it pays to know if their is any fundamental reason for the stock pullback.

And to be honest:

If you’re focused on buying strong companies with great financial statements then most of the time your stock market pullbacks are just minor hiccups on the way to higher prices. But it’s important to take a quick second and make sure you don’t buy the pullback in the stock if there is a material fundamental change. Make sense?

At the end of the day, trading stock market pullbacks can present you with great opportunities for profit. Just make sure you do a little due diligence before doubling down. Using technical and fundamental analysis can help you understand the nature of the stock market pullback and whether it is an early warning sign or an opportunity to re-enter your stock idea at lower prices.

And By The Way: If you’re looking for more tactics and techniques for improving your stock market performance, I encourage you to sign up for email updates below to get exclusive stock analysis and trading ideas…

Leave a Reply