Buying Pullbacks In Mature Trends May Be Hazardous To Your Account

2016-08-09 | David Starr

Buying pullbacks in an uptrend sure sounds easy when markets are going up. “I’ll buy the next pullback,” a trader might tell herself without accounting for how that idea might feel when the pullback actually arrives. The idea of buying feels good when the market is going up. When it turns down, even if the selling is only temporary, buying feels scary.

So what is a trader to do? How do we avoid buying right as an uptrend is ending? I do it by taking some of the concepts from Elliott wave analysis and turning them on their head. Some people love Elliott wave and some loathe it. I find by taking a slightly different take I can embrace the best parts of the tool and avoid those which have led to results which turn people off. One of the concepts I use is trend maturity and it helps me to know which pullbacks to buy and which to avoid.

One of the core concepts of Elliott wave is that moves in the direction of trend unfold in five waves and moves against the trend are three-wave moves. Let’s take a look at a weekly chart of the S&P 500 and the move up from the 2009 low. I’ve attached roman numeral labels to the waves: I represents the end of the first wave; II represents the end of the second wave; etc… This appears to be a trend move to the upside and if the labels are right then it could be near the end of its move.

SPX Weekly - Buying Pullbacks

Here’s where one of the common criticisms of Elliott wave is accurate: we don’t actually know that the labels are accurate and in the right place. We will only know after the fact. Even so, it displays all the hallmarks of a five-wave move and that means it is a move in the direction of trend. So even if the actual labels are in the wrong place, the trend is clearly up.

However, once we can identify a reasonable fourth wave (down into the IV label) and a fifth wave up (which now appears to be in progress) then we want to identify the trend as becoming mature. Unlike some Elliott wave advocates, this doesn’t mean I want to immediately look to short the market because we don’t know that the move is over; we won’t know until after the fact. But it means that we want to be less aggressive about buying pullbacks.

At this point, we need to address timeframe as Elliott wave patterns unfold in all timeframe. We are looking at a move which is becoming mature on a weekly chart. That means I no longer want to be so aggressive about buying pullbacks which are visible on the weekly chart. Since the trend is up the waves in the direction of trend (such as the move up into the wave I label, from II up to III, and from IV up to V) should also unfold as five-wave moves. If one of those moves isn’t yet mature, then it might represent a buying opportunity on that timeframe. Let’s drill into the highlighted region on a daily chart for an example.

SPX Daily - Buying Pullbacks

This chart exposes the structure of the move up from the February, 2016 low which we expect to unfold as a five-wave move since it is in the direction of trend. We can identify the first wave up labeled circle-1. The different levels help identify the different degrees of waves. After circle-1 we have circle-2 but circle-3 through circle-5 do not appear complete and this means that the move up which began in February is not yet mature and on the daily chart and lower timeframes, pullbacks can be bought.

Now notice the move up from the circle-2 low. We’ve identified a smaller degree 1-2-3-4-5 move which looks like it is becoming mature. Don’t fall into the trap that most people get caught in when they first learn about Elliott waves – don’t use this as an invitation to start shorting this market. We don’t know that this leg up is over. However, this is a warning that now is a dangerous time to buy when this specific leg up looks mature. Instead, wait for the next big pullback. As long as the daily patterns up from February appear incomplete, buying pullbacks should work.

This is just one of the tools the Elliott wave analysis gives us to help remain on the right side of markets. By getting past the simple view of “reverse once you count to five” approach we can get a nuanced view of the trend which helps us plan and execute trades in a disciplined manner.