Correction
A correction on the stock market is not only a decrease, but also an increase in the quotations of securities, which runs counter to the trend, but does not stop or change it completely.
To begin with, let's fix the notion of a trend in the stock market. A trend is the general direction of quotations on the chart. As a rule, the value of the asset moves in a wave-like manner over time. However, its general movement is directed upwards, downwards or stays on one level. The following types of trends are distinguished:
- Upward (bullish), which are caused by the growth of quotations.
- Downward (bearish) trends which appear when prices are falling.
- Flat where the price stays on the same level.
At the same time correction is called a short-term deviation of quotations from the current trend. As a rule, deviation is 10% or more of the current values. It can be expressed either in price fall or its growth which goes against the trend. At that, the general direction doesn't turn and doesn't stop.
The correction is simply understood as the desire of the price to correct in the direction of its fair value. Often it happens after the rapid growth because of high demand from buyers. In this case the general growing trend is preserved.
In trading, the correction is most often said about the fall in prices during a prolonged trend. The correction is also called a pullback.
Types of Corrections
There are two basic types of corrections in trading:
- upward;
- downward.
The upward correction is the one where the main trend of the asset on the market is moving downward, but prices have started to go up. The downward correction takes place when the trend is up and prices have started to fall.
Some investors in the market refer to a sideways movement as a pullback. In this case, the correction is called flat. Anyway, the sideways movement has no clearly defined direction. The quotes keep on one level and go sideways. As a rule, the sideways movement comes after a strong fall or rise of quotes.
The side correction is a kind of pause for the market and traders before returning to the main movement. Usually at this time the number of buyers and sellers is equal and no one is able to form a new trend.
Reasons for occasion of Сorrection
Any events not directly related to the stock market can provoke a drop in quotations: economic, political and corporate news, natural and man-made disasters, epidemics of diseases.
There are several main reasons for the beginning of corrections. The market mood can influence the price significantly as the worries about the financial statements or the success of the company put pressure on the price of the asset or push it. Also, the situation in the world like changes in the law, economic or political news have their own impact on the price movements. When traders start to actively sell assets, the number of buyers decreases and the price falls.
Often corrections in the stock market are a consequence of psychological tension of bidders. For example, in anticipation of news the number of sell or buy positions may grow, provoking an imbalance of supply and demand. This will lead to downward movement of quotations under negative factors and upward movement under positive ones.
At the same time, the potential for growth is much harder to predict. A small negative movement can make many traders and investors start to sell shares.
Margin-trading and stop-loss or stop-limit orders influence the price as well. If an investor purchased the asset at the price peak, then during a downward correction there is a risk of losing part of the invested funds.
Those traders who utilize leverage and trade on margin are most likely to suffer losses in case of the correction. If assets begin to lose value, the investor will receive a margin call from the broker. It means that at the current price his debt increases. Therefore, it is necessary to replenish the balance of the brokerage account, otherwise the broker will close the positions at the current value.
In such a scenario, some traders begin to actively sell the stock at the current price. As a result, quotations fall and the price no longer corresponds to reality.
Frequency of Corrections
Small and short corrections in the value of assets on the exchange occur frequently. If a trader has been on the exchange for more than a year, they surely experienced both falling and rising prices.
A deviation of more than 10% normally occurs about once a year. Major corrections within the range of 20-40% occur l once in 5-7 years. Such events are able to affect related assets in the sector.
Sometimes real collapses take place. During such periods, quotes on the market fall by 40-70%, leading to the bankruptcy of companies. Fortunately, this happens very rarely and only during events of global scale.
Appearance of Correction
The correction process in the stock market usually takes place in two waves of asset sales. At the beginning of the first wave, the price holds at the maximum level in sideways movement mode. So far, the quotations are not going to rise even more or to go down. This situation discourages new buyers who are not willing to buy shares at high prices or who forecast an imminent correction.
As a rule, some event initiates the movement of the first wave. For example, negative financial statements, a public announcement, changes in the legislation, etc. The number of sell orders increases like an avalanche, traders want to get rid of the assets as quickly as possible, reducing the value. Competition among sellers is formed.
Here the second wave begins and the stop loss orders are triggered. At the same time, most investors are not willing to buy the rapidly decreasing asset. Such a development is largely due to the reaction of the speculators, who sell the shares at the slightest danger. Such behavior increases the volatility of the asset, which negatively affects quotations.
Then the situation begins to improve. Usually everything happens in one day from the beginning of the trading session. The number of bids for purchase of the fallen asset increases, the news background is normalized. Growth in demand for the asset pushes quotations up, and the trend comes back to its course.
Pay attention! After the pullback, the return to previous levels does not happen always. Sometimes the price falls far short of its previous value, and the comeback itself takes a long time.
Duration of Correction
Usually the correction on the stock market lasts about 3-4 months. From a trading standpoint, this is a short period. However, it can seem dangerous for novice investors to hold an asset that has lost in value for so long. Such a development causes psychological pressure that can lead to erroneous and unprofitable operations.
In trading it is important to learn how to keep cool and rational thinking. You must learn to use the current situation competently and make profit out of it.
It is quite difficult to foresee a new correction on the market. The stock market itself is only possible events and probabilities. It is much more useful to always keep in mind that a pullback will happen sooner or later. It is useful to have a personal plan of action for such developments. Likewise, it is difficult to predict exactly which assets will be affected by a new stock market correction. It is best to follow agency analysis and news feeds. Everything has its prerequisites.
Pluses and minuses of Correction
The correction, like any other phenomenon in the stock market, has advantages and disadvantages.
Advantages of the correction. If an asset is overvalued and is clearly worth more than its real value, a pullback shifts the level closer to the fair price. As a result, the stock becomes more accessible to other investors. From this perspective, we, as potential buyers, get the opportunity to buy the desired securities. This is called an asset revaluation.
Disadvantages of the correction. Sometimes a correction ends in a complete trend reversal. Then the market becomes bearish, and the return to the former positions will take even more time. This is the worst case scenario.
Also during the corrections the short-term investors and traders suffer losses, especially those who use the leverage. Falling prices can lead to panic in trading. Traders begin to sell assets in droves, pushing the price lower and lower.
