Pullback or Reversal in Trading: How to Spot the Difference?
In this article, I will discuss Pullback or Reversal in Trading: How to Spot the Difference? Please read our previous article discussing the Top Mistakes to Avoid When Pullback Trading and How to Overcome Them.
Introduction to Pullback or Reversal in Trading:
Two of the most important concepts that any trader needs to understand to trade successfully are pullbacks and reversals. Understanding the difference between reversals and pullbacks may determine the difference between a profitable trade and a losing one.
In this post, we’ll explain pullbacks and reversals and their respective importance and provide a few tips on determining which one you’re dealing with. Understanding pullbacks and reversals may be challenging for traders of all experience levels, so it’s critical to have a strong foundation to build your trading knowledge.
We’ll discuss what to look for when determining price action and common patterns that signal a pullback or reversal. Understanding these concepts can make it easier to see potential trading opportunities and avoid making costly errors. So, let’s examine the main differences between pullbacks and reversals in trading.
Let’s go through a Practical Example
Any trend-following trader has once questioned if the pullback they are watching is only a retracement in trend or a complete trend reversal. You may prevent pullbacks when the price is actually reversing and hold onto winning trades longer by understanding the major distinctions between retracements and reversals.
Before the most recent pullback, the price was clearly trading within a strong bearish trend, so let’s assume you were short. You expect the price to start trading in the direction of the bearish trend if you could determine whether this most recent move was just a retracement, and you would be able to hold onto your profitable trade for a longer time.
On the other hand, if you could identify whether this move was, in fact, a reversal rather than a pullback, you may expect the price to continue to move higher and could, therefore, close out your short trade while still in profit or minor loss.
What are Pullbacks and the Psychology behind Pullback?
A pullback is a temporary or short-term price movement against the dominant trend. Later, it resumes back into the main dominant market direction. For example, an uptrend-down move considers a short-term pullback in the uptrend. Pullbacks are sometimes referred to as price Correction or retracement in dominant trends. Pullbacks are often seen as healthy corrections within an overall trend, and they can provide traders with better opportunities to enter positions at more favorable prices. The key to success in the pullback trading method is understanding the difference between a pullback and a failed pullback.
The price never moves in a straight line in any financial market; it is often expressed in bullish (rising) and bearish (falling) waves. For example, during an uptrend pullback, the price goes lower (against the dominant up waves, CALLED impulse waves) before rising again in the direction of the main trend. When trading pullbacks, traders watch for those corrective waves to time trade entries during these corrective waves.
As you know, price move is a zig-zag form
- Movements with the trend are called “impulses/extensions.”
- Movements against the trend are called “correction/retracement/pullback.”
Let’s start by taking a look at retracements. A pullback is a temporary or short-term price movement against the dominant trend. Later, it resumes back into the main dominant market direction. Take a look at an example of a retracement on the nifty daily chart below:
With price trading in a bearish trend, you can see each pullback was a short-term price movement that moves against the current dominant trend, and later, it resumes back into the main dominant market direction. Each pullback on the chart was a temporary move and didn’t signal a change in the overall trend from bearish to bullish.
What is a Reversal?
A reversal, on the other hand, is a longer-term change in the direction of a trend. flipping from a bullish trend to a bearish trend and vice versa. Reversals are characterized by a change in the overall pattern of higher highs and higher lows in an uptrend or lower lows and lower highs in a downtrend. Now, let’s compare the above with a look at reversals. Check out an example of a reversal on the 5 MIN NIFTY chart below:
Here, you can see that the pullback was a reversal, as the trend changed from a bearish trend to a bullish one.
Pullback vs Reversal – Key Differences in Trading
Pullbacks are temporary price retracements that occur in the direction of the main trend. In contrast, failed pullbacks are price movements that initially appear to be pullbacks but break through a significant support or resistance level. Identifying pullbacks and failed ones in a chart can be challenging for traders. To determine whether a price movement is a pullback or a reversal, traders must consider several key factors. These include
- The overall trend
- Price action at a key level of support and resistance
- Volume and momentum behind the pullback
By carefully analyzing these factors, traders can better differentiate between pullbacks and reversals and make more informed trading decisions.
Overall trend or context
Identifying the current trend and its strength is the first step for traders to take to determine if a move is a pullback or a reversal. This can be accomplished using price action and technical analysis techniques, such as trendlines, chart patterns, and the strength of an impulse move.
The current trend’s strength can indicate whether a price movement against the trend is likely to be a pullback or a reversal. A strong trend is less likely to reverse completely, while a weak trend may be more vulnerable to a reversal. For more details about identifying strengths and weaknesses in trend, click here.
Key Level of Support and Resistance
Traders also look at key support and resistance levels to determine whether a price movement is a pullback or a reversal. Pullbacks typically occur at support or resistance levels, where buyers or sellers are expected to step in and retake market control.
you can see that the price retested previous resistance as support each time a retracement occurred. As long as these support zones were in an uptrend, there was no reason to suspect that these pullbacks indicated a trend reversal. Each pullback on the chart was a temporary move and didn’t signal a change in the overall trend from bullish to bearish and vice versa.
However, if the price breaks through a key level during a pullback and fails to continue in the original direction of the trend and after the breakout of the key level of support zones were holding in a downtrend (bounce from support in uptrend expect failed pullback or trend reversal).for more about reversal structure click here.
Volume and Volume Analysis
Volume: In simple terms, the volume factor refers to the amount of trading activity during a particular period. Volume can indicate whether a price movement is a pullback or a reversal.
A pullback typically occurs on lower volume than the initial trend, and volume tends to decrease as prices move against the trend, and this is due to profit booking. Pullback shows mixed candle candles with volume decreasing.
As you can see in the above chart example, A pullback typically occurs on lower volume than the initial trend. Volume tends to decrease as prices move against the trend and mix candle candles with volume decreasing. We want to prefer these types of pullbacks when entering pullback trading.
A reversal or failed pullback often occurs on higher volume as traders and investors adjust their positions or take positions in anticipation of the new trend. Failed pullback shows consecutive strong candles with volume increasing; it may be a sign that the trend is weakening, and a reversal may have occurred.
Spread of Candle
In the case of a pullback, traders should look for momentum divergence to signal that the counter-trend move is likely to be temporary.
- A great mix of red and green candles
- Closes towards the middle with wicks
On the other hand, if there are strong indications of increasing momentum in the opposite direction of the prevailing trend, this may indicate that a reversal is taking place.
- Strong consecutive candle close
- and size increasing
|Factor to study
|A pullback typically retraces a small portion of the prior move
|Reversal is nothing but a failed pullback and retrace full
|Context (overall trend)
|A strong trend is less likely to reverse completely
|while a weak trend may be more vulnerable to a reversal
|The key level of support and resistance
|support zones were holding in the uptrend.
|support zones were holding in a downtrend after breaking off the market structure
|pullback shows mixed candles with volume decreasing
|Failed pullback shows consecutive strong candles with volume increasing
A great mix of red and green candles
Closes towards the middle with wicks
Strong consecutive candle close
and size increasing
In this article, I will discuss 2 Pullback Trading Strategies You Must Know as a Trader. In this article, I try to explain Pullback or Reversal in Trading: How to Spot the Difference. I hope you enjoy this Pullback or Reversal in Trading: How to Spot the Difference article. Please join my Telegram Channel and YouTube Channel as well as my Facebook Group to learn more and clear your doubts.
About the Author: Pranaya Rout
Pranaya Rout has published more than 3,000 articles in his 11-year career. Pranaya Rout has very good experience with Microsoft Technologies, Including C#, VB, ASP.NET MVC, ASP.NET Web API, EF, EF Core, ADO.NET, LINQ, SQL Server, MYSQL, Oracle, ASP.NET Core, Cloud Computing, Microservices, Design Patterns and still learning new technologies.