Contrary to what we all might wish for, even the very best stocks don’t go straight up for months on end with no corrections.
The same goes for the stock market as a whole. Even during the strongest bull moves, painful corrections occur.
These corrections often last days, but sometimes they last weeks and still don’t disrupt the overall uptrend.
The dirty little secret that amateur traders fail to understand is that pullbacks are a good thing…IF they’re “constructive” in nature.
While it’s no fun to watch your portfolio drop during a session – or even several sessions – professional traders understand that constructive corrections give stocks (and the market as a whole) a chance to adequately rest up and continue their upward moves.
If stocks go up continuously without normal “resting” periods, they become much more susceptible to sudden and dramatic crashes. These crashes can be brutal to a portfolio and extremely difficult to recover from.
Normal (constructive) corrections help stocks avoid these sudden crashes.
So what makes a pullback constructive and how do we tell the difference between a “constructive” correction and a “dangerous” correction?
Three things, actually:
1) Constructive pullbacks occur on lower volume.
Volume tells us how much conviction is behind a price move. If we see heavy volume, it tells us there is more force behind a move, it’s more aggressive. If we see lighter volume, it tells us there’s uncertainty behind the selling, not everybody’s buying into the move.
Ideally, we want to see pullbacks occur on volume that is less than the previous day’s volume and/or less than the volume seen on recent up days.
2) Constructive pullbacks don’t break below key support levels.
Nicolas Darvas, the father of the Darvas Trading System, was famous for recognizing that the best stocks actually pulled back quite often and quite dramatically, but they never fell through their key support levels (which Darvas usually identified with his famed “Darvas Boxes”).
When pullbacks occur, we don’t want to see them fall through key trend lines or moving average lines that have been maintained throughout the overall uptrend. Pullbacks that break these levels are a big warning sign, even if they don’t actually trigger a sell-stop. (All the key support levels and sell-stops for CURRENT Darvas stocks are explained in the current issue of Darvas Trader PRO.)
3) A single day’s action is rarely a cause for concern.
Even the best stocks (and strongest bull markets) can have a brutal session here and there. The key is that they usually recover quickly. A single day of selling is rarely a cause for concern, even if it does occur on higher volume. Some profit-taking during a strong bull move is to be expected and sometimes this profit-taking creates panic among the market’s weaker holders. This type of behavior can produce some wild one-day swings.
However, a constructive market environment will normally rebound quickly by reversing higher or leveling off in the days that follow the dramatic decline. Top traders don’t get spooked out of winning positions based on a single day of selling.