Shallow Pullbacks
Identifying Good Pullbacks
First, we want a stock to be above its 200-day moving average before we buy it. Why? Because stocks tend to trade higher more consistently in pullbacks above their 200-day moving average than below it.
We tested a stock’s behavior above and below its 200-day MA looking at over 8.25 million trades from 1995-2006. What we found, is that the average gain for all stocks above their 200-day MA five days later was comfortably ahead of the average gain for all stocks below their 200-day MA when looking ahead five days.
Simply stated, it’s better to be buying stocks above their 200-day MA than below. When stocks break down under their 200-day MA, they often have a tendency to continue dropping.
Catch a Falling Knife?
A good example is Freddie Mac (FRE | charts | news | PowerRating):
As you can see, the stock reached above $60 per share, and after closing under its 200-day MA, it proceeded to collapse into the $20’s. Within a 30 day period of time, the stock lost more than 50% of its value. By staying away from the stock once it broke under its 200-day MA, you would have avoided a great deal of pain and losses that fund managers and investors felt when they bought it much higher, believing it was a cheap stock. In reality, it was a falling knife, and the 200-day MA rule often helps us avoid stocks like these.
Citigroup (C | charts | news | PowerRating) is another example:
10-Day Highs versus Lows
Before looking at the various levels of pullbacks you’ll want to focus on, we’d like to share a research study of ours. The study looked at the average gain per trade for all stocks above their 200-day MA making 10-day highs (breakouts) versus those making 10-day lows (pullbacks). The exit was a close on the opposite side of the 10-day moving average.
The average gain for the stocks making 10-day lows was more than three times greater than the stocks making 10-day highs. This test is one of the strongest pieces of evidence that the short-term edges have been greater when buying a pullback versus buying a breakout.
Three Types of Pullbacks
There are three types of pullbacks we want to focus on. They are shallow pullbacks, mid-level pullbacks and deep pullbacks. Each has its pluses and minuses, and when you blend them together, you have a combination of pullbacks which potentially gives you a healthy trading edge. In this lesson, we’ll look at shallow pullbacks.
Shallow Pullbacks
What is a shallow (or small) pullback? It’s exactly as it sounds. It’s an up-trending stock which pulls back for a few days, before resuming its longer-term up-trend. These types of stocks are usually momentum stocks giving fund investors little opportunity to accumulate the stock at lower levels.
This chart of Freeport-McMoRan Copper & Gold (FCX) is a good example of shallow pullbacks:
10-Day Lows
Now that we have these filters, let’s first look at stocks that closed at a 10-day low. We’ll also need to exit these stocks (there is no more guessing when to exit!), so we’ll exit once the stock closes above its 10-day simple moving average.
A 10-day low is exactly as it sounds. It’s a stock which closes at its lowest price over the past ten trading days (today inclusive). As you can see from these results (Jan 1, 1995 through Sep 30, 2007), these stocks have had an edge.
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Entry
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Exit
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Avg % Gain/Loss
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% Correct
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# of Trades
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10-Day Low
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Close > 10-Day MA
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1.29%
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69%
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262,400
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Stocks which have made 10-day lows using these filters and exits have outperformed the average of all stocks. And they have outperformed 10-day highs by a very healthy margin.
Here are two examples of stocks which made 10-day lows and then rallied to close above their 10-day MA:
As you can see, the stocks pull back to levels which attract buyers, and then resume their moves higher.
Since 1995, if you bought each stock using this criteria, each day at a 10-day low, and exited when it closed that day above it’s 10-day MA, you would have been profitable (before slippage and commission) 69% of the time, and your returns would be more than double versus randomly selecting any stock during this period of time. This is the beginning of you finding trades which have had historical edges.
2-Period RSI
Now, let’s look at stocks which have a 2-period RSI below 5. Before we do that, we want to make sure you understand what a 2-period RSI is.
What is RSI? It’s an oscillator which measures the strength of a stock on a 0 to 100 basis. The stronger the stock has been, the higher the RSI is likely to be. Most charting packages and books look at the 14-period RSI. This is too long for traders (and we can find no statistical evidence that a 14-period RSI has any edge). We use a 2-period RSI, as that is one of the best ways to identify how overbought or oversold a stock is. Ideally we want to focus on stocks whose 2-period RSI is below 5.
When we use our filters and then look at all stocks that have had an RSI below 5, we see edges. For example, from Jan 1995-Sept 30, 2007, buying a stock with an RSI below 5 and exiting on the close when the 2-period RSI closed above 70, you would have been correct 70% of the time (before slippage and commission). And the average gain was 1.69%, approximately three times greater than the average gain for all stocks during that 12 ¾ year period of time. These are healthy edges and it shows you that edges trading edges can be found when using the proper entry and exits.
Here’s an example of a stock with a 2-period RSI below 5 that then traded up and closed with a 2-period RSI above 70:
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