Being able to discern between a pullback and a downturn is an incredibly valuable skill that can yield you a much higher return on your investments.
So how do you tell the difference between a slight “dip” in the market and a reversal of movement?
There is no simple answer.
There is no single indicator that allows for that “aha” determination. However, if you learn how to read the signs, then there are indications that when added together can allow you to be much more confident in your assessment.
The first indicator: your trend line (if you haven’t seen my post on that, take a look HERE first). You should start to be very cautious once the bars cross your trend line.
Let’s take a look at this daily Starbucks chart. Initially, we have a really tight trend line with very little variation away from the line, but then on April 16th (blue arrow) we see that the red bar goes below our trend line. So does this equate to a reversal?
From what we can see (even “into the future”) on this chart, it isn’t clear.
If we adjust our trend line to this purple line then we see that we get a couple more weeks until a bar (this one green) once again breaks through the trend line. So does this mean a downturn?? What if you haven’t drawn the “perfect” trendline?? (Yes, I clearly stated that there is no “perfect” trend line.)
In looking at what we can see into the future of this chart, it doesn’t look like a downturn, just some “readjustment” time. This is not at all atypical and we still need to be able to determine when a true downturn is present.
So how to tell the difference then?? Clearly, crossing a trend line is not the only indicator that we need to look at, but it is usually the first one that draws our eye.
Let’s dive a little deeper into this chart. The first time that the stock broke through our trend line (blue) was with a red bar — but not a really substantial red bar and there was no major increase in trading volume (on the bottom of the chart). This was followed by a second red bar (once again, relatively small) and then onto a green bar. From the bottom of the wick of this second red bar (the low point), we will draw a horizontal line (orange) and extend it into the future. This line will become our second indicator.
In following the chart into the future — having drawn our second (purple) trend line — we see that when the stock breaks through for the second time, it is actually on a green bar, followed by another 2 green bars. Having crossed in the middle of a field of green suggests that maybe the trend line that we have drawn is simply too steep. Nevertheless, it deserves some attention from us.
Still continuing with this chart, we see that after our “field of green”, the stock takes a decent drop with a red bar, but once again, there is no real increase in trading volume (a third indicator that we will keep in mind).
Looking at our horizontal line that we drew after the first crossing, we see that the stock stays above this orange line for several more days until there are 4 red bars in a row and the wick of the last bar crosses the line. Importantly, the bar closes above the line. Looking at our third indicator, we see that there was some increase in the trading volume on the previous red bar, but that it did not maintain that level. This still means to proceed with caution; the stock has not indicated a clear path up or down yet.
Continuing into the future with this chart, we see that after this last red bar there starts to be definite upward movement again and we can draw another trend line (bright blue) that fits this pattern. In looking back at the period of time in the black rectangle, we see that this is a classic pullback; the stock lost value, but it was not a reversal in the trend, but rather a “blip” in the grand scheme of things.
So what indicates a true downturn?
Continuing with the same Starbucks chart, we see that our last (bright blue) trend line continues into the future and holds fairly well until August 12th, when it clearly breaks through and is followed by additional days that are definitively below our line. This is our first indication that there is either a pullback or a downturn.
With the stock having crossed our trend line, we then want to draw a horizontal line from the low point (in this case we go back a couple of days to August 5th) and carry that line into the future. The stock stays above this orange line until September 10th when it not only crosses below, but clearly closes below as well. This is our second indicator.
Finally, we want to look at the volume of trading and we see that there is a definite uptick in the number of shares traded — nearly double from the previous bar. This is the third indication that the stock has changed directions. While volume is not a perfect indicator, it can help to confirm our suspicions about a downturn.
So were we correct in our assessment?
Looking into the future once again, we see that, yes, there was a definite downturn with this stock and we can easily draw a fourth (bright green) trend line to indicate this. While this downturn only lasts ~2 months, we are able to see this change because we are looking at a daily chart.
Long term Investing:
If you are looking for long-term investing, then you will want to set your time frame to be either weekly or monthly. The same indicators work just as well, they will simply be more in line with the time frame of your investing and less reactive.
In looking at the weekly chart above, you will notice that the same trend lines are present, but they don’t necessarily align with the highs and lows of the new candles as well. This is because the candles have different points once you change the time frame. The same directional trends are present and the same indicators are used to determine pullbacks vs trend reversals.
This works for any chart on any stock or ETF. You can use the same indicators for your stock portfolio as well.
So that’s the not-so-simple answer as to what constitutes a pullback vs a reversal and how you can identify them while they are in progress.
Take a look at this video where I walk you through the analysis of a different stock to gain even more insight into how to discern a pullback from a reversal.
Here are a couple useful links that you might enjoy:
✅ If you like the look of the charts that I used in all of my examples, these are real-time charts that are offered free through this link: TradingView
✅ If you are interested in a great trading platform where you can get two free stocks just for opening and despositing $100, check this out: WeBull
✅ Interested in learning more about Coach John? Read his story HERE.