It is said that the main differences between successful and unsuccessful trend traders is the ability to distinguish between good, bad and ugly pullbacks.
Another way of putting it is that one should read between the lines… On one hand, you’ll want to avoid trend pullbacks that are overly aggressive. On the other hand, make sure the momentum stays intact and avoid markets that slide into a sideways, consolidating range. Finally, watch out for “wild” momentum scenarios that inevitably turn out to be blow-off tops. That is when average candlestick expands multi-fold, indicating a high level of emotion. That type of price action is not suited for pullback trading because the rally inevitably is short-lived, with an asymmetric risk/reward profile. In short, what we’re looking for is a more orderly, “hesitant” pullback.
Short vs. Long Term Momentum
The Zerolag Oscillator is designed to identify favorable pullback setups. First, it enables you to apply Perry Kaufman’s Efficiency Ratio, comparing momentum with volatility for directional bias (more information on the Efficiency Ratio here). The long term momentum is aligned with the short-term, spotting temporary weaknesses in strong, healthy trends. Specifically, the color of the zeroline indicate the longer timeframe trend bias, i.e. the Efficiency Ratio reading, whereas the histogram values show the short term momentum.
The Bullish Pullback
You may spot bullish pullbacks on positive histogram values with Efficiency Ratio readings that show a neutral or up-trending market. White paint-bars will point to a short-term adverse move, cutting into and testing the new trend. If buyers are taking advantage of the oversold, getting in at lower prices and pushing a continuation move, a lime green paint-bar will plot. Such initial trend confirmations are then defined as Key (K) Signals with a stop placed a few ticks below the setup bar, or the signal bar, whichever has the lowest low. One may use subsequent signals, Retracement (R), to add to the initial position. One would then re-adjust the stop, placing it a few ticks below the new setup or signal bar.
The Bearish Pullback
You may spot bearish pullbacks on negative histogram values with Efficiency Ratio readings that show a neutral or down-trending market. Yellow paint-bars will point to a short-term adverse move, cutting into and testing the new trend. If sellers are taking advantage of the overbought, getting in at higher prices and pushing a continuation move, a bright red paint-bar will plot. Again, the initial trend confirmation is defined as Key (K) Signal with a stop placed a few ticks above the setup bar, or the signal bar, whichever has the highest high. Subsequent signals are defined as secondary Retracement (R) Signals and may be used to add to the initial position. The stop would then be re-adjusted, placing it a few ticks above the new setup or signal bar.
Pullback Trading with Institutional Participation
When evaluating pullbacks, it is a good idea to gauge whether institutional traders are likely to participate. Obviously, you‘re more likely to see significant price movement when big players participate. So how do you anticipate whether institutional traders are likely to be part of your pullback trade?Well, their main challenge is to avoid moving the market and keep execution costs in check when entering large positions. Therefore, they’ll look for areas where there’s plenty of supply / demand.
That is found within one standard deviation of the Volume Weighted Average Price. It is the volume weighted arithmetical mean of all transactions that take place during the session. Prices for every transaction are added and divided by the total contracts traded during the session and statistically, 68% of all trades occur within one standard deviation from the VWAP where institutional traders are likely to position themselves (check out our Spotlight on the VWAP here).
Once prices move towards the outer standard deviation bands, institutional traders are likely to take a step back and wait for the market to return to value. The idea is therefore to look for pullbacks in this area, being mindful of whether the momentum is intact while watching out for reversals that are too aggressive.
Directional Bias, a Second Opinion
We already discussed how the Zerolag Oscillator aligns near / long-term momentum when identifying pullback trades. But as we know, it‘s generally a good idea to review bias from different perspectives. Just as with legal or medical advice, you‘ll want to get a second opinion when it comes to directional bias.
Conclusion: Pullback Trading
Successful pullback trading depends on the ability to read between the lines and avoid the most common causes for failed pullback scenarios. We’re looking for a strong trend and momentum, but not wild volatility or a pullbacks that show up on aggressive rejection candles.
Also, you’ll want to align your pullbacks with scenarios that are likely to see institutional participation, i.e plot within the first standard deviation of the VWAP. We then supplement with a directional bias from the regular open.