What it means
Prices rarely rise in a straight line. Even in a strong upward trend, the price steps back from time to time as some holders sell to bank profits, and the pause can last a few days or several weeks.
A pullback sits at the mild end of a scale of price declines. A fall of around 5% to 10% from a recent peak is often called a pullback, a larger fall of 10% to 20% is usually called a correction, and a decline of 20% or more is commonly described as a bear market (a prolonged period of falling prices).
Pullbacks happen for ordinary reasons. Investors may take profits after a rally, a piece of mildly disappointing news may arrive, or a share may simply have risen too far too quickly and need time for earnings to catch up with the price.
Traders often watch for pullbacks as entry points. They look for the price to dip toward a level where it has found support before, such as a moving average (the average price over a set number of days), and then buy in the hope that the earlier uptrend resumes.
Businesses meet the idea in several ways. A treasurer deciding when to buy foreign currency for a supplier payment may wait for a pullback in the exchange rate, and a company planning a share buyback may time its purchases to dips in its own price.
The difficulty is that nobody knows in real time whether a dip is a pullback or the start of a reversal. Disciplined investors therefore set a limit in advance, such as a price at which they will sell, to protect themselves if the fall turns out to be more than a pause.
In practice
Real-world examples.
Example
A technology share has doubled over a year and then drops 8% in a fortnight after the sector is hit by profit taking. A portfolio manager who wanted to build a position sees the dip as a better entry price. She buys in two stages, half now and half if the price falls a little further.
Example
A treasurer at a furniture importer needs to buy $2,000,000 of currency in the next two months to pay a supplier. The exchange rate has been moving in the wrong direction for weeks, so she places an order to buy a portion if it pulls back by 2%. Her aim is to improve the average rate without gambling on the full amount.
Example
A listed software company's board has approved a $10,000,000 share buyback over the year. The finance team spreads the purchases, buying more heavily on days when the price dips below its recent average. This lowers the average cost per share repurchased.
Formula
Calculation
Pullback % = (recent peak - subsequent low) / recent peak x 100
Retracement % = (recent peak - subsequent low) / (recent peak - prior starting point) x 100
Suppose a share rises from $40 to a peak of $50 and then falls to $45.50. The pullback is (50 - 45.50) / 50 x 100 = 4.50 / 50 x 100 = 9%. The earlier gain was 50 - 40 = $10, so the share gave back 4.50 / 10 x 100 = 45% of its rise. A pullback of 9% would normally be treated as ordinary, whereas a fall to $40, a full 20%, would signal something more serious.Case study
Seen in the real world.
Redwood Components is an illustrative, fictional listed manufacturer whose share price rose strongly after two good results announcements. Then it fell 9% in two weeks with no company news, and some staff holding share options began to worry.
The chief financial officer explained to the board that the move looked like a normal pullback, driven by investors taking profits across the whole sector. She showed that the fall was less than the 12% drop the shares had seen in each of the previous two upswings, and that the company's earnings forecasts were unchanged.
The board decided not to alter its plans and the shares recovered within a month. The illustrative lesson is that a dip needs context before anyone reacts to it: compare the move with the market, with history and with the facts about the business.
Watch out
Common mistakes.
- Assuming every dip is a pullback and buying without checking whether the underlying business has changed.
- Selling in panic during a normal pullback, which turns a temporary paper loss into a permanent one.
- Treating pullback and correction as identical, when the terms describe different sizes of decline and different levels of concern.
Questions
People also ask.
How big is a typical pullback?
There is no official size, but people commonly use the term for dips of roughly 5% to 10% from a recent high, with larger falls called corrections.
How can you tell a pullback from a reversal?
You cannot be certain at the time, but a pullback usually comes with unchanged fundamentals and holds above earlier support levels, while a reversal tends to break those levels on heavy selling.
Do pullbacks happen in bond and currency markets as well as shares?
Yes, any market with a trend can show a pullback, including bonds, commodities, currencies and property indices.
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