A pullback trading strategy is a trading strategy that involves buying a stock after it has experienced a recent decline in price. The rationale behind this strategy is that the stock is likely to rebound from its recent decline and return to its previous price level or even higher.
Pullback Trading Strategy. We have previously discussed and written why the 200-day moving average works: because you play defense if a severe recession hits. But can you combine a long-term defensive trend-following strategy using the 200-day moving average with a long-term pullback trading strategy?
Pullback Trading Strategies
In this article, we backtest a combination of long-term trend-following and short-term pullback strategies to create a long-term pullback trading strategy that incorporates breakout pullbacks and retracement techniques for stocks.
The 200-day moving average
First, we recommend reading two other articles we have written about trend lines and averages, including the 200-day moving average. These articles will provide insight into pullback trading strategies and breakout pullbacks.
- The 200-day moving average: How it works, why it works, and why it doesn’t work
- A simple trend-following system/strategy on the S&P 500
The 200-day moving average, along with pullback trading strategies and trend lines, works well in the stock market because it allows for breakout pullback opportunities and helps you identify major bear markets early on. The downside is that you may underperform during periods where there are no significant averages or pullbacks to follow.
The stocks market has a long-term uptrend and you can still manage decent returns with significantly less drawdowns if you use pullback strategies with the 200-day moving average as a trend filter. Pullbacks are common in stocks, but by using this trend filter, you can minimize losses and maximize gains.
Enter on pullbacks in the direction of the trend
The 200-day moving average defines the long-term trend and we only want to go long if the trend is positive. But because the S&P 500 has shown strong tendencies of mean reversion since the mid-80s, we go long at short-term pullbacks if the long-term trend is positive. Thus the name pullback trading strategy.
Thus, we make the following strategy (in plain English):
- The close must be above the 200-day moving average.
- The close must be below the 20-day moving average.
- The five-day RSI must be below 45.
- If 1-3 are true, then enter at the close.
- Exit at the close when the five-day RSI ends above 65.
Alternatively, you can apply pullback strategies and enter the forex trading market at the next day’s open with a slightly lower total return, taking advantage of potential pullbacks.
How have these simple trading strategies performed since the inception of SPY (The ETF that tracks the S&P 500) stock price?
This is the equity chart of 100 000 compounded from 1993 until September 2021, showing a clear uptrend in stock price. Additionally, investors can monitor this stock on IG for real-time updates.
- CAGR is 8.3% (buy and hold 10.5%)
- Time spent in the market is only 30%
- Max drawdown is 30% (during covid-19 mess)
- Win-ratio is 82%
- Average winners are 1.9%, average losers are -2.3%
The 200-day moving average is a valuable tool for traders as it helps to identify uptrends and pullbacks in trading. It also does a good job of keeping traders out during long and severe recessions like in 2000-2003 and 2008/09.
Some readers might ask: what’s the point of this system when it underperforms the buy and hold strategy in the stock market? Despite its attempt to predict price movements and capitalize on pullbacks, this system falls short in comparison to simply holding onto stocks for the long-term. The unpredictable nature of the market makes it difficult to consistently outperform a buy and hold strategy.
This is, of course, a very relevant question. The main “asset” of this strategy is its very low exposure time in the market which reduces the max drawdown.
Pullback Trading Strategy
Amibroker’s backtest report provides a risk-adjusted return, which is the return adjusted for the time spent in the markets. Our long-term pullback trading strategy has a risk-adjusted return of 27%, thanks to our ability to identify price pullbacks and follow the trend. This has been a reliable source of profit for us.
The trading strategy experienced a significant pullback during the Covid-19 market turmoil in March 2020, highlighting that the biggest drawdown is always lurking around the corner. It’s important to remember that trends and prices can shift rapidly in the market, and even the most successful strategies can falter. If you’re in the game long enough, you’ll inevitably face a big drawdown.
But overall, we believe the long-term pullback trading strategy works pretty well and most likely can be significantly improved.
How does the 200-day moving average play a role in pullback trading strategies?
The 200-day moving average is valuable as it helps identify uptrends and pullbacks, minimizing losses and maximizing gains. It also aids in keeping traders out during long and severe recessions. The 200-day moving average acts as a trend filter in long-term pullback trading strategies. It helps identify major bear markets early and allows for breakout pullback opportunities.
What are the key criteria for the pullback trading strategy outlined in the article?
The strategy involves entering the market when the close is above the 200-day moving average, below the 20-day moving average, and the five-day RSI is below 45. Exit occurs when the five-day RSI is above 65. The strategy has a Compound Annual Growth Rate (CAGR) of 8.3%, a 30% maximum drawdown during the COVID-19 period, and a win ratio of 82%. It provides a risk-adjusted return of 27%.
What is risk-adjusted return, and how is it calculated in the context of the pullback trading strategy?
Risk-adjusted return is the return adjusted for the time spent in the market. The pullback trading strategy has a risk-adjusted return of 27%, indicating its ability to identify price pullbacks and follow the trend. Despite attempting to predict price movements and capitalize on pullbacks, the strategy may underperform buy and hold due to the unpredictable nature of the market.