A Tactical Review of the Classic Pullback

05/17/2010 11:04 am EST


On May 4, the S&P 500 broke down from a head and shoulders top on its daily chart (Figure 1). Immediately after prices penetrated through the 1183 neckline of that pattern, panic set in over the Greek debt crisis and the stock market moved into a freefall for the rest of the week. The following week, prices rallied hard, paring off the previous week’s losses with a powerful three-day winning streak, catapulting an impressive 62 points.

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But despite the forceful rebound, technical traders have not been persuaded that this bounce back has any teeth. The rally has stalled at the 50-day moving average (MA). Just above that, the 20-day MA is slanting down over prices, intersecting with horizontal resistance, which was the neckline of the head and shoulders topping pattern.

The mere fact that prices have been unsuccessful in climbing above these moving averages tells us that the bears may be lurking overhead. After breaking down from the bearish head and shoulders pattern, support has now turned into resistance and prices are now testing that resistance level (Figure 1).

More often than not, after prices break down or break out from a pattern, they will gravitate back to the point where the initial break took place to create the first pullback. This is called a backtest. In this case, the S&P 500 had a robust rally after the sharp decline, as bargain hunters and bottom fishers came in to push prices higher. As prices pulled back against the ensuing downtrend, short sellers got squeezed into the rally, being forced to cover, driving prices even higher. When the short covering comes to a conclusion, buying sentiment will dry up and prices should resume the downtrend.

For the backtest to be a success, we need to see both the 20- and 50-day MAs bear down over the top of price, causing it to crumble. If price continues to struggle and is just too feeble to rise above the moving averages, it will take the path of least resistance and skid back down to the next support zones—first to the 200-day MA and then below that at the February low.

Assuming that prices continue to fall and then find support at the February low, it may hint that the S&P 500 is carving out a massive head and shoulders pattern that began in late 2009 (Figure 2).

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The classic pullback presents the trader with tactical maneuvers that can be used on trading instruments that have parity with the S&P 500, such as the S&P 500 electronically traded fund (SPY).

A trader can contain risk by shorting the pivot reversal and then putting the initial protective stop just above the 50-day MA or the last minor high. If prices plow through the 50-day MA, the stop will be triggered with just a small loss. Those with more risk tolerance can place a looser stop above the 20-day MA. Often times, prices will remain below the 20-day MA throughout an entire decline, allowing traders to utilize trailing stops above the declining 20-day MA to capture the majority of the downtrend.

Glancing back at Figure 1, you’ll notice a red candle that formed after the three-day advance. The red candle’s real body was contained within the prior white candle’s trading range, forming a bearish two-day candle pattern called a bearish Harami. This reversal candle pattern will be validated once prices drop below the low of the two-day pattern, which was made on May 12. Should the pattern be validated, it will offer traders another opportunity to go short. An intraday move below 1155 will trigger the trade, or a trader can wait for the pattern to get a confirming close before implementing the trade. The stop can be set slightly above the highest point of the Harami pattern.

The classic pullback offers a low-risk entry point because the moving averages are above the price, which increases the odds of another lower high forming. Because of the enormous amount of overhead resistance involved, you have four groups of traders circling over resistance: Those shorts who want to add to their positions, those who missed the downturn altogether and are now eager to place their bets against the market, longs who want to get out just so they can break even, and shorts who sold too early and are looking for another opportunity to take a position.

The powers of predictability increase when correlating multiple time frames to determine future price direction. On the 60-minute chart of the S&P 500 (Figure 3), it suggests that there is more downside to come. 

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A bearish divergence has set up between price and the moving average convergence/divergence (MACD) histogram, as it sank below the centerline. That action caused the MACD (12, 26, 9) to rollover in a bearish cross. Meanwhile, the stochastic (14, 3, 3) took a nosedive, and the negative directional indicator (-DI) (red line) crossed above the positive directional indicator (+DI) (green line) on the average directional indicator (ADX) (14). If the ADX line (black line) bottoms out and begins to rise, it will strengthen the bearish cross. The direction indicators on the daily chart also have a bearish cross (Figure 1), further suggesting more downward pressure in the days ahead.

Understanding market psychology gives us insight as to why we so often see pullbacks. But once a pullback (backtest) has run it course, prices turn and resume the previous trend. Now not every backtest will be successful—sometimes they fail as the previous trend attempts to reassert itself—but in order for the bulls to take back control, they will need to push the S&P 500 above its 20- and 50-day MAs. Keep your eyes on the moving averages because they will give us a good reference point from which to determine the strength or weakness of the current downtrend.

By Ron Walker of TheChartPatternTrader.com

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