A common behaviour observed in many traders is that each move tends to make them believe that it is a long-term top or a long-term bottom but in a real world scenario, the market will not move vertically up or down. It will have interim adverse moves, commonly known as pullback which are different from a trend reversal.
Let us understand both these terms and then we will look at some data points that can help us identify these.
The terminology
Reversal
A reversal is when the market changes its direction from bullish to bearish or vice versa. For a reversal to happen, it requires enormous adverse force to establish a new trend. Often traders tend to tag temporary moves as reversals and ultimately lose to whipsaws.
Remember, reversals will occur less than 20 percent of the time, so if you see an adverse move, probably it is still in the favour of the previous trend.
Pullback
A pullback is a common phenomenon where the market or instrument tends to witness some temporary adverse moves. If it is properly utilised, it can provide an opportunity to re-participate in a major trend. Pullbacks do not need a lot of force to lead to this.
How to differentiate between a pullback and a reversal?
A pullback is different from a reversal as it is temporary. Tracking some data points can help differentiate between the two.
Built-ups
Derivative built-ups are a data points that can be analysed to establish a conclusion. Let’s assume that the market was moving up and naturally lots of long additions must take place. When the market starts correcting, it would be important to check if the correction is due to the unwinding of previous trades or new shorts being initiated.
If the overall Open Interest of the futures is reducing, it will mean that traders who were earlier long are now booking profits. Profit-booking is temporary in nature and does not define a trend and this occurrence can be termed as a pullback.
If the correction is due to increasing Open Interest, it means new trades are being initiated to participate in the trend and can be termed as a reversal.
Skew
Options skew can be another indicator in understanding the quantum of fear. If the option skew is not highly affected, it would derive the confidence of writers in holding their trades being an expectation of a temporary correction.
Trading a pullback
When the market or an instrument is in a pullback mode, instead of short selling (in a bullish market) which is against the overall trend, it would be prudent to wait for the correction to end. Technical oscillators, mean-reversion models, etc can be used to identify over-sold zones and odds favour that those levels will be respected.
Let us say the Nifty is in an uptrend and a pullback starts with diminishing Open interest and the 20 days rolling return coming down to 2 Standard deviation, that would be an opportunity to buy. Similar systems can be built using technical indicators as well.
Strategies for pullbacks
Since pullbacks can be time-consuming and you would not know the exact bottom, strategies cannot be aggressive. Option strategies that are conservative in nature can be used to participate in a pullback. Some of the strategies could be Vertical Spreads and OTM butterflies, which generally offer a comfortable reward to risk and also allow additional time to save on theta decay.
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