As traders, we all know the market can be unpredictable, but by understanding and utilising pullback trading strategies, we can take advantage of temporary price reversals to enter positions at more favourable prices. In this article, we’ll dive into the world of pullback trading, explain the concept of mean reversion, and look at how to use tools like the moving average indicator and Fibonacci retracements to identify potential pullback levels.

What Is a Pullback?

In the past, you might have seen stock traders discussing their plans to wait for a pullback to load up on shares and wondered, “but what is a stock pullback?” In fact, pullbacks occur in prices of all tradable assets, including commodities and forex trading pairs, such as EUR/USD and AUD/USD, not just in stock prices.

A pullback refers to a temporary reversal in the price of an asset after a period of upward or downward movement. If you’ve ever heard of “correction” or “retracement,” these are just other terms used to describe pullbacks. It's where the price cools off slightly before continuing its overall trend, and it is often the result of profit-taking by traders and technical factors, like key areas of support and resistance.

Why Do Pullback Trading Strategies Work?

Trading pullbacks in trends plays into the notion that “the trend is your friend.” In other words, trading in the direction of the higher-timeframe trend will typically yield the best results. But why does this strategy work? The easiest way to think about it is in the context of “discount” and “premium” pricing.

Discount and Premium Pricing

Imagine you have a bullish trend, like the one in the example above. Here, traders run the risk of buying at one of the many highs that make up the trend, paying more for a single unit of an asset than is potentially necessary (paying a premium) and resulting in sub-optimal risk/reward. Given the premium pricing, the number of buyers will taper off until sellers take control and push prices lower.

Conversely, pullbacks allow traders to get in once the price cools off, meaning they can enter at a discount. At this point, buying pressure will be at its strongest as many know these low prices often won’t last and that they can offer much better risk/reward ratios, maximising the profit for traders from the overall bull trend.

Mean Reversion

This concept relates to the idea of mean reversion, which states that prices tend to return to their average over time. By entering a position during a pullback, traders can buy an asset at a lower price, or at a discount, with the expectation that the price will eventually return to its average.

Notice that in the chart above, for example, the retracements typically fall below the midpoint of the previous retracement and the 50-period moving average before continuing higher. Additionally, we can see that the further the price moves away from these two averages into areas of previous premium or discount, the more likely it is to reverse.

As you’ll see, these ideas form the basis for several commonly used pullback trading strategies. Understanding how the concepts work, however, will help you develop your skills as an effective pullback trader and allow you to trade under a variety of market conditions.

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