Pullback – A Technical Perspective
Everyone has heard Cramer yell about his favorite stock, usually one which is in the middle of a big rally. And, he always finishes by warning you to buy on a pullback. But, what exactly is a pullback? The answer depends on your investment outlook – trader or investor, long-term or short term.
From a trader’s perspective, a pullback is exactly that. A short term fall in the stock price that represents a buying opportunity assuming that the stock’s uptrend stays in tact. Usually these are transient fluctuations in stock price, not to be confused with a correction which many traders view as a 10% drop in stock price after a long rally. A correction usually results in a period of stagnant price movement known as a base before a new upward rally can begin. We’ll deal with those in another post.
The pullback is a near term buying opportunity and is analogous to a stock catching its breath after a sprint. But, only long enough to get recharged for another dash. Trading of a stock from day to day is typically dominated by a game of greater fool. (I don’t mean this negatively despite the connotation.) Market participants buy and sell day in and day out on the assumption that they will be able to sell at a higher price to someone else. The interesting thing about the market is that typically, these shorter term oriented people will get caught up in the exuberance and the stock will accelerate upwards. Then, tentative holders of the stock or other members who seek to lock in profits will begin to sell. The stock will fall slightly, where it will be beneficial for others to jump in and try to play the game all over again.
The key to understanding the difference between a pullback and a correction and an all out free fall is resistance and support. Resistance and support points represent valuations points for the stock that seem adequate in the short term. That is, the majority of market participants will buy the stock at the support point and sell it at the resistance point. Breaking through these invisible valuation barriers represents a shift in overall market mentality. Breaking down through support implies that there’s been a material weakening of the stock’s valuation and breaking up through resistance implies improving outlooks on the stock’s valuation. The following chart shows an analysis of an uptrend as well as indications of pullbacks and optimal buy points for someone looking to ride upward momentum in the stock.
Here, we take a look at Coach’s run from July 2006 to July 2007. Unfortunately, for short term traders hoping to ride the momentum, waiting for a pullback would have proved difficult as we never saw a true pullback until 3/4 of the rally was done. The first circle you see is the first time the stock ever pulls back to test resistance. This would have proved to be a good buy point for those looking to make a quick one month trade as the stock quickly rebounded from $43 to $50. The stock then took a hit a month later, but what we see is a day in which the stock traded down, flirted with breaking both resistance and its primary uptrend, but came back to finish the day near the top of its range on strong volume. Buying power continued after this and gave the stock its last gasp towards $55. What’s interesting about this is that we also see that overall volume has begun to decrease signally an end to the market’s fervor for this stock. This is a red alert for anyone holding the stock as it signals a likely shift in the sentiment towards this stock and makes it a likely candidate to take a big hit on any negative news. As expected, we find the stock drops in what initially looks like a pullback, but the stock fails to maintain pricing power along its primary uptrend (red flag #2), makes a try at regaining momentum, but can’t set a new high (the last circle) and begins a new trend down. The rest is history. The stock began a 40% slide to its current price.
Support and resistance points are easy to spot in hindsight, but anticipating them is difficult. Typically speaking, a truly short term investor – day trader, week trader – can often anticipate round numbers as areas of support or resistance as many traders will naturally set their limit and stop orders at or around them. Another decent projection for an initial resistance level would be that of the trendline drawn. Breaking trendline resistance does not necessarily mean a bearish note, but it can mean that the bullish trend is decelerating. The key to identifying whether the uptrend is broken or merely decelerating is for a stock to maintain new resistance at levels higher than the previous low. This shows continued buying strength and is the only way to confirm an uptrend. Read my post on drawing trendlines for a more in depth description.
That’s it for now. We’ll look at a more fundamental view of pullbacks and corrections in future posts.
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