Supercharge Your Trading Portfolio with Momentum Pullback Strategies

Introduction: Harnessing the Momentum in the US Stock Market

Momentum pullback trading strategies capitalize on the natural ebbs and flows of the market by identifying stocks with strong trends that are temporarily reversing. For intermediate day and swing traders, these strategies offer the potential for consistent returns and reduced risk exposure. In this article, we’ll dive into the specifics of swing momentum pullback strategies, explore their pros and cons, and create a complete systematic rules for momentum pullback strategy trading highly liquid US stocks.

The Ins and Outs of Momentum Pullback Strategies

Momentum pullback strategies take advantage of temporary market inefficiencies by identifying stocks with strong trends that are experiencing short-term pullbacks. Traders enter positions when a stock’s price begins to rebound, riding the momentum back in the direction of the primary trend.

Pros:

• Increased odds of success by trading in the direction of the prevailing trend
• Potential for high returns in short periods
• Clear entry and exit signals for easy implementation

Cons:

• Susceptible to sudden trend reversals and false signals
• Requires a disciplined approach to risk management

Momentum pullback strategies can contribute to a trading portfolio by increasing overall returns and diversifying trading opportunities, especially during periods of market volatility.

Crafting a Momentum Pullback Strategy: Key Components

Let’s create a momentum pullback trading strategy for highly liquid US stocks priced above $5.

Trading Universe

Our trading universe will consist of highly liquid US stocks with a minimum price of $5. We’ll focus on stocks listed on major exchanges like NYSE and NASDAQ with average daily trading volumes of at least 500,000 shares.

Market Context

We’ll target stocks in a strong uptrend, as defined by the stock’s price trading above its 50-day and 200-day moving averages. Additionally, we’ll look for stocks that have outperformed the S&P 500 index over the past three months.

Position Scoring

To prioritize potential trade opportunities, we’ll use a scoring system based on Relative Strength Index (RSI) and Average True Range (ATR). The scoring system will help us select stocks with the highest potential for a strong rebound from their pullbacks.

• Calculate the 14-day RSI for each stock in our trading universe that meets the market context criteria.
• Calculate the 14-day ATR for each stock.
• Normalize RSI and ATR values on a scale of 0-100.
• Calculate the position score as follows: Position Score = (Normalized RSI x 0.7) + (Normalized ATR x 0.3)

The higher the position score, the more attractive the stock is for a potential trade. Prioritize stocks with the highest position scores for your 10 open positions.

Entry Rules

1. Identify stocks in a strong uptrend using the market context criteria.
2. Calculate position scores for each stock using the RSI and ATR-based scoring system.
3. Wait for a pullback of at least 10% from the stock’s 20-day high.
4. Confirm the pullback by ensuring the 5-day RSI has reached a value of 30 or below, indicating oversold conditions.
5. Enter a long position on the following day open and prioritize stocks with the highest position scores.

Exit Rules

1. Set a stop-loss order at the lower of: (a) 1% below the low of the previous day, or (b) 2x the 14-day ATR below the entry price.
2. Set a profit target at a 1:2 risk-to-reward ratio or at the stock’s 20-day high, whichever comes first.
3. Exit the position if the stock’s price closes below its 50-day moving average.
4. Alternatively, exit the position if the 14-day RSI reaches a value of 70 or above, indicating overbought conditions.
5. Sell on next day open

Risk Management

Allocate 10% of your trading capital to each position. This will help to limit potential losses and maintain a diversified portfolio. Strategy does not use leverage.

Number of Open Positions

To reduce correlation risk and maintain diversification, limit the number of open positions to 10 at any given time.

Performance

Remember: this strategy is just for studying puposes and is not inteded for use in live trading. However, you have now clear idea what components such quantified strategy should have and you can start to experiment on your own. Lets check stats of given strategy – Ive performed Amibroker backtest from 1.1.2015 to 31.3.2023 on US Stocks from Russell 3000 (Interactive Brokers commissions included, no slippage).

Strategy generated 1554 trades annual return of 23.86% with max drawdown of 37.5%. Those results are very good when you compare performance against a benchmark. Its cool starting point to start work on while trying to make your first momentum pullback strategy. As you can see, strategy is on max drawdown right now – its performing quite poorly right now (first quarter of 2023) because of current market contex – US stocks are in the bearish trend at the moment and momentum pullback strategies are having the best results in bullish market conditions – this is the reason why its so important to trade multiple strategies in portfolios.

My Own Variation For Swing Momentum Pullback Strategy

In my portfolio I have multiple swing momentum pullback strategies. One called Second Wave – which is designed to trade bit more frequently and have another rules to identify pullback and with same backtest parameters have performance like this:

Same trading principle, but more fine-grained rules and we get annual return of 23.86% with max drawdown of 30%. Its definitly worth it to develop and join momentum pullback into your trading portfolio.

Final Thoughts: Implementing Your Momentum Pullback Strategy

Now that you have a momentum pullback strategy for highly liquid US stocks, it’s time to put it to work. While given strategy is definitely not for live trading, you can create your own backtests based on those rules and start working on your own strategy. Keep in mind that successful trading requires discipline, patience, and consistent risk management. Remember to continuously monitor your strategy’s performance and make adjustments as needed. With a well-rounded approach and a focus on position scoring, entry, and exit rules, you’ll be well on your way to supercharging your trading portfolio with momentum pullback strategies.