A correction is a decline of 10% or more in the price of a security from its most recent peak price. Corrections can affect assets such as individual stocks or bonds or an index that measures a group of assets.
Assets, indexes or markets can fall into a correction either briefly or for a longer period spanning days, weeks, months or longer. On average a market correction can last anywhere between three to four months.
Charting methods are used by investors, traders and analysts to forecast and track corrections to give them visibility of market conditions. Macroeconomic shifts and problems in a company’s management plan can contribute to the triggering of a correction, but other factors can also trigger one.
How a correction works
Corrections are always lurking in the market but it can be hard to determine when they will make an appearance. Given their short-lived nature, they aren’t too much to worry about for long-term investments, markets will eventually recover making little difference to the investments.
However, when a correction occurs in the course of one trading session it can make a big impact on short-term or day trades. As these types of trades are usually leveraged the losses can soon add up.
According to LPL Financial Research the S&P 500 has averaged a correction a year since 1950. And in 2020 it saw four separate corrections, although it hasn’t seen a correction since March 2020.
It is impossible to pinpoint when a correction will start or end, but analysts can look at historic data of past corrections and plan accordingly. It can however be possible to project a correction by analysing markets and comparing indexes against each other.
By reviewing price support and resistance levels, technical analysts can predict when a reversal or consolidation may turn into a correction. Technical corrections occur when an asset or entire market is overinflated.
The tools used to chart corrections include the use of Bollinger Bands, envelope channels and trendlines to determine where price support and resistance can be expected.
Advantages of a correction
The advantages of a correction include:
Creates buying opportunities
A decrease of 10% or more of the price of an asset such as a stock or index can create buying opportunities for investors who otherwise couldn’t invest. As the price falls it will bring investment opportunities within reach to a wider audience.
Calms over-inflated markets
A correction can help readjust and calm asset valuations for assets that may have been come unsustainably high. Over-inflated markets create volatility as it is hard for them to sustain their prices so a decline is inevitable.
Disadvantages of a correction
The disadvantages of a correction include:
Can cause panic
As it is impossible to accurately forecast when a correction will end, the start of a correction can lead to panic amongst investors and can result in a rise of overselling. This panic selling is usually based on fear rather than analysis.
Decline can be prolonged
When a correction happens whether to a single asset or a whole index, it is impossible to predict how long the correction will last. While most will recover within 3 to 4 months and some may only last several days or weeks, there is the possibility that a correction could take longer to recover resulting in a prolonged decline.