A Reliable Trading Edge in the Stock Market

Sometimes it can seem complicated to make money in the stock market. There are so many ideas out there for how to approach the market. Which strategy should you use? And which strategies actually work?

There’s one strategy that has paid off for investors repeatedly over the years: buying pullbacks.

If the price of a stock drives upwards for several days and then settles down somewhat gently, almost as if it’s taking a breather, that’s said to be a pullback. It’s a great time to buy when a stock is in a pullback.

For many people this isn’t a new idea. Buying pullbacks is a pretty well-known trend-following strategy.

But it may help to know the actual statistics for how effective this strategy is. I’ve always had trouble trusting any given trading strategy without knowing exactly how it’s performed historically.

I used a back-testing software to research the performance of pullback trades over the last 20 years. I came up with a measure for how to determine if a stock price was going up “forcefully” as well as a measure for when the price was in a pullback. I then took 1,000 major stocks (ones with a market cap of $10 billion or more) and looked for all the situations where they met those criteria. There were more than 29,000 total trades in the test.

A candlestick chart and trading screen

The results: over the last 20 years, 57% of the time you would have come out with a victory if you had taken the pullback trade I tested.

That’s a really solid edge. To put it in perspective, if you:

  • had a 57% win rate
  • did 100 trades in a year
  • risked 2% of your account balance on each trade

Then you’d end up with a 29.7% return on your account for the year. That’s a return that many would be quite satisfied with.

There are more statistics to consider though, the most important of which might be the drawdown. The drawdown refers to how far the account balance would have gone down from its peak value at any given time by performing these trades.

My research showed that over the entire 20-year period, the median drawdown was a little over one quarter of the amount of the average annual return. This means that for our example above, where our trading strategy would have earned a 29.7% return, the typical drawdown would have been around 8%.

For many people, that’s an acceptable risk to reward ratio.

Another statistic that’s helpful to know is the variance of the returns over those 20 years. The years that performed the worst were the ones that immediately followed the dotcom bubble burst (2001-2002). In those years, buying pullbacks was a wash from a profit perspective. Most years, though, were relatively stable, which makes this a solid strategy in the majority of market conditions.

Profit, loss and risk

On top of all that, this strategy is a swing trading strategy, so it doesn’t take a lot of your time to administer the trades once you set them up. And if you don’t want to take the time to find the pullbacks on your own, you can use a stock trade alerts service that will alert you exactly when to enter and exit pullback trades like these.

As profitable as it’s been to trade pullbacks overall, it may have been hard to stick to it through market downturns or account drawdowns. But if you had found a way to just keep trading pullbacks year in and year out over the last 20 years, you likely would have generated plenty of wealth.

Of course just because pullback trades performed well in the past doesn’t guarantee the future. But for my money, I sure like knowing that there is a proven quantitative historical edge with the trades I take.

This article is for information and educational purposes only and does not form a recommendation to invest or otherwise. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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