Before I get too far into this post I would just like to say that I am not calling for a pullback now in the indexes (because who truly knows), but did think it was an appropriate time to talk about this.
When I first began to trade, or least first began to study the markets I was told “learn to love pullbacks”, and “Pullbacks are good”. At the time I never fully understood this concept. My thinking was “Market pullbacks are bad, I do not want to lose money, I want to trade long.”. Maybe none of you were like I was, or maybe you are and do struggle with this. Either way, I am going to tell you what I have came up as an answer to this question.
Market pullbacks do two main things. One, allow new bases to form. And Two, Allow the market to regain momentum.
1. The BASE is probably the most essential part of most technical traders formula, and analysis. Without a strong base, a technical trader will likely skip the particular security as it does not offer the best Risk:Reward in that area. As the market pulls back from a high, and then hits a support line, and bounces off to trade back to resistance it has essentially formed a channel AKA a base. Now that the market has formed a new base it can use that to launch off of for higher or lower prices as well as offer better risk:reward to traders.
2. Along with the new bases the market also creates new momentum, and these two things go hand in hand. Think about momentum like you would gas for a car, and think about extending price like a road for a car. Now, as a car travels down a road (price), it uses gas. Eventually the car will run out of gas the further it goes. Not immediately, not all at once but slowly but surely the car will run out of gas. The same is true for the market. As we extend in price, our ‘gas’ (momentum) begins to wane.
Most traders in the market trade off momentum, and the more there is, the more successful these traders will be. Pullbacks can be thought of like a gas station. Gas stations may take time away from moving forward, but without gas eventually there is no more moving forward. Gas stations allow you to refuel your car so you can travel further in the long run. This analogy can be directly applied to the stock market. Pullbacks are the gas stations, and without them the market cannot travel as far over the longer term.
Where most traders get in trouble is they try to guess “how big the gas tank is”. What I mean by that is when traders use the momentum indicator (MACD) as an indicator when it starts to show divergence to trade off of it is essentially trying to guess the exact mileage you will run out of gas once the “blinking” light comes on in the car. There is no use for that in trading, there is no guessing, and trading off a guess from a warning sign is not good enough. No one knows how big the spare tank is.
I could go on and on with more analogies, and more about momentum but I won’t (at least for this post). In summary, basically pull backs allow the market to create more favourable risk:reward scenarios (bases), and allow the market to “refill the tank” (momentum). I hope this helps explain some of the often said, but rarely explained concepts of the market. Let me know if you have any questions. You may contact me for questions/comments by Twitter (@BenCBanks) or StockTwits (@BenCBanks) or Email (Contact Page).