Are You Buying Pullbacks or Trying to Pick Bottoms?

An ongoing discussion in studying the markets is when/how one should go about buying a stock. Some like to "buy pullbacks", some like to "buy breakouts", these two are thought to be completely different entry strategies and yet I could argue that you can employ both strategies simultaneously without violating either of the underlying meanings between the two. How, you ask, can you buy both a pullback and a breakout? That doesn't make any sense you might say. Well the answer lies in your understanding of the larger context of the asset in question.

Most traders take such a short-term view of the market and their positions that they cannot understand blending these two concepts into an actionable and successful entry strategy. Take CAT as a perfect example of this (I had this same conversation with a friend of mine recently).

Here is the Daily chart of the last 6 months for CAT:

You can see on the 6-month Daily chart I entered CAT after a strong surge in prices that took out the prior highs and appears to be a "breakout buy" (which it is, especially in this context).


The pullback buyers would argue I could have just waited until later the next week to get a better entry or I could have really made out huge if I had bought the big drop 3-weeks later in late January. While it is true that I could have made more had I bought the day before CAT released their Q4 earnings report (Jan 27th), I would be hard pressed to find someone with strong risk management principles that would be willing to buy that huge flop heading into a highly volatile earnings report. In hindsight it would have worked perfectly, but hindsight is ALWAYS perfect.

The discussion I had with my friend was that he wanted to buy into CAT and liked the breakout, but it seemed like it had moved "too far" to buy where I did. He likes to buy pullbacks, yet the "pullback" if that's what you want to call that pre-earnings plunge was too risky for him to buy also. He uses strong risk management practices with his positions so this one just didn't fit his setup. And that's fine, you can't buy them all. But he really liked CAT and wanted to buy it, he just simply couldn't find the "pullback" he wanted. Since that conversation CAT has gone on to rally strongly and is positioned for more upside in my opinion, but that's beside the point.

The point is that if he had zoomed out the view and taken in the context of the bigger picture, my "breakout entry" looks a lot different. Here is the wider, Weekly view:

While it is true that I didn't "pick the bottom tick" here in CAT, my entry point looks a lot like a "pullback" buy considering where the prior highs have been over the past 2 years.

What I'm trying to get across is that those who seek to squeeze every dollar or tick out of the market are going to be very frustrated and stressed and will likely miss out on many strong opportunities. There is a common maxim on Wall Street that the best moves never give you a comfortable entry point. This is exactly why I prefer the clarity of new multi-week highs to enter a position rather than hoping I can save a buck a share and get an even better entry.

 If you simply take a longer view at things you can find appealing values that have corrected from the highs and have actually put in a bottom in price and begun to reverse higher. By not being overly greedy and trying to anticipate every low in the market, you can identify circumstances where risk/reward favors a particular low risk entry.

This "buy the dip" mentality that many Wall Streeters share generally requires much emotional discretion when buying a stock. I hear it time and time again in the financial media; the analysts beg for a pullback to put money to work, then when the pullback comes they don't pull the trigger because they think the pullback will go further than this and they can get an even better buy. The problem is that pullbacks never come on comfortable news and nobody rings a bell to indicate that the pullback is over. This behavior continues to perpetuate itself as the market recovers before the pullback should have ended and then the same analysts are sitting on the sidelines waiting for the next pullback. The important distinction I want to make here is that those types of traders are destined to fail as they are constantly looking to "pick the bottom tick". It's not news that no one can do this with any sort of regularity. Even the "best" market timer, many consider this to be Tom DeMark, has been calling a Top for this market since last summer. Guess what, he has been continuously wrong. Even someone who is considered the best at picking turns in the market can't do it with any consistency, what makes you think you can?

If you take a step back and try to identify places where prices have stopped declining and are starting to reverse higher, that is where you can make strong entries. They won't get you the seat on CNBC talking about your "bottom call", but it will make you money in any market while taking less risk to your mental and monetary capital. You will never see me exit a full position at "the Top" and you will never see me enter a position at "the Bottom". Trying to time those events causes much more harm than good to your investment accounts. Its better to find a successful, consistent entry plan and just take what the market gives you. If you try to take every tick out of the market, you will lose.

Here are a few other "pullback breakout" buys I have made recently to show how this works:

EOG

 DDD summer 2013

AMGN

These are just meant to be examples to how you buy after a pullback while price is breaking out to resume the uptrend. I am not trying to show how good I am or anything, because I'm not. I am simply a student of the markets and try to take what the market gives me. I don't want to be a hero and pick bottoms or call tops, I just want to trade stocks where I have a long term advantage from a risk/reward standpoint. Through much trial and error I have found that waiting for a stock to setup and reverse after a pullback/correction seems to be a winning strategy over simply lunging at a declining stock near a prior support area.

Buy the breakout after the pullback and the money will flow. Your account balance will thank you.


While it is true that Entry signals get all the glam and attention, the real challenge is when to Exit a position, as that truly is the dominant factor that determines whether you made money or not. As this is the case I will discuss the subject of Exits in a followup post in the near future. Good trading!