A pullback is a temporary drop in an asset’s long-term uptrend. Pullbacks are typically drops of about 5% to 10% and are very short-term. They are common in a bull market.
What causes a pullback? And when should you be concerned that a stock decline is actually a longer-term trend? Let’s go over the basics of what pullbacks are and why investors consider pullbacks to have both opportunities and risks.
Definition and Examples of a Pullback
A pullback is a short-term drop in an asset's value, usually between 5% to 10%. Pullbacks are common temporary setbacks in longer-term uptrends.
- Alternate name: Retracement, Consolidation
Pullbacks are when the market price of an asset briefly retreats. These temporary declines are anomalies caused by the basic law of supply and demand. Basically, as a stock’s (or other asset) price increases, fewer buyers are willing to pay the higher prices. Eventually, as demand declines, prices start to fall to a point that attracts more buyers.
Pullbacks are different from reversals, which are when the price continues to drop instead of returning to an uptrend.
Reversals can occur for many reasons. For example, a company’s earnings report may signal bad news to investors, say if its earnings or revenue fell significantly short of analyst expectations. The result could be a lasting decline based on real-world events instead of a short dip.
Let’s look at price trends in Zoom Video Communication Inc.’s (ZM) stock, which generally increased throughout most of 2020 during the pandemic.
You can see that Zoom’s upward trend throughout most of 2020 was interrupted by smaller declines in price. These dips could be considered pullbacks because the price trend quickly returned to its overall positive momentum. In contrast, after October 2020, you can see Zoom’s stock reversed its broader course into a downward trend. So, the declines that began at that time were not a pullback, they were a reversal.
How a Pullback Works
Let’s go over how pullbacks work by describing how they are used in pullback trading, a day trading strategy. The pullback trade starts with an uptrend. Investors identify a stock that has been increasing. The longer an asset has been trending up, the more likely it is that the established trend will continue.
Investors then determine an entry point, which is where the pullback comes in. Investors can plan to buy when the stock retreats a certain percentage, taking advantage of the discount and then riding a price trend higher.
The key is to figure out whether the drop is a temporary pullback, or if it is a longer-lasting correction or even the start of a long-term downtrend. One indicator of a pullback may be lower trading volumes. With a reversal, you are more likely to see higher trading volumes on declines.
Investors can use several strategies to help them try to take advantage of pullbacks:
- Pay attention to the fundamentals: Studying earnings reports can provide good information about whether a company is having issues.
- Wait and see how low the pullback goes: If the pullback breaks through support (often measured by the established trendline), it will probably become more than just a pullback. It could be a longer-lasting reversal.
- Check the volume of the stock: If the volume increases during a dip, that could signal that the sellers are taking over in a longer-term sense.
What It Means for Individual Investors
For both short-term and long-term investors, pullbacks have opportunities and risks to consider. Investors who can identify pullbacks and invest in a way that takes advantage of the asset’s return to gains can profit from them, joining an uptrend at a good price.
However, pullbacks do have potential downsides. Namely, an investor who mistakes a reversal as a pullback can suffer losses instead of gains.
Pullback Vs. Correction Vs. Reversal
Pullbacks, corrections, and reversals refer to drops in the price, only to different degrees. While there are no clear-cut definitions, pullbacks are usually considered brief declines of 5% to 10%, corrections are declines of 10% to 20%, and reversals are longer-term declines of typically over 20%.
Pullbacks are smaller, shorter declines than corrections. But in both cases stocks or other assets eventually resume their upward momentum, creating a temporary setback within a broader positive price trend. In contrast, a reversal is a longer-term downward shift in the overall price trend.
To take advantage of pullbacks, corrections, and reversals as buying or selling opportunities, investors try to determine the type of decline trend they are seeing. They try to identify when a perceived correction is really just a pullback or when a pullback may turn into a reversal.
Understanding the cycle is crucial. Most reversals won’t happen until several pullbacks and corrections shake out all the bulls, as noted trader pioneer William O’Neil says in his book “How to Make Money in Stocks.”
- Pullbacks are a short-term, temporary drop in the price of an asset like stock during a longer-term uptrend.
- Investors targeting a particular asset can find buying opportunities during pullbacks, although they would need to weigh other factors.
- Reversals, which are not the same as pullbacks, are longer-term declines usually caused by a change in fundamentals, not due to anomalies of the law of supply and demand.