My trading strategy aims to capture ‘with trend’ trades against countertrend pullbacks. The method that I try to employ is to enter on the break of the trendline of the pullback. There are numerous trading sites describing the technique how a trendline break should be traded. In a previous post I quoted Al Brooks, the writer of the book ‘Reading Price Charts Bar By Bar’, how he interprets countertrend pullbacks. Another representation of trendline breaks was described by Vic Sperandeo in his book ‘Methods of a Wall Street Master’ and known as the 1-2-3 reversal.
There are several ways that the price can break a trendline. The tricky part is to be patient and endure the provocation to jump straight into action when the price is forcing its way through the trendline. The best way is to wait until a minor pullback (in the direction of the countertrend pullback that we are trading against) tests and confirms the breakout. Both of the above mentioned methods emphasise the key element of a pullback testing the trendbreak.
On the above chart I marked the trendlines of three pullbacks against a bullish trend. The breakouts show different types of trendline breaks. The first breakout did not retest the breakout and the only way it could have been traded was the breakout above the small doji just before the break of the trendline. The second trendline breakout had a retest of the level of the breakout while the third retested the trendline itself with a higher low. In fact both latter examples formed 1-2-3 reversals. I also marked a fourth trendline which was tested but not broken. The sharp selloff that followed was a clear example why it is important to wait for break of the trendline.
These examples also show how deep the pullbacks were on the fibonacci scale. The first two pullbacks reached and exceeded the 61.8% fibo retracement level. The third didn’t even scratch the 38.2% level. It is worth note that the angle of the pullback trendlines are also different which suggests that the momentum of the pullback does not necessarily provide any clue about the quality of the breakout.
The second chart shows two reversals after trendline breaks which tested the extreme of the prior trend. The aggressive way to enter is to place a stop entry order below the low of the bearish pin bar testing the prior high. A more conservative entry method is a stop order below the swing low prior to the test of the extreme. In case of the second example – which was a perfect pullback trade – the price retested the conservative entry level as well offering a second entry for the conservative traders.