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What is a correction in trading
Financial Literacy
Key takeaways:
- A correction in trading is a meaningful price drop, commonly around 10% or more from a recent high, over a short period. It can last days or weeks and does not mean prices cannot continue falling further.
- Corrections happen when a security’s price moves well above recent trends and then falls back towards a more expected level. This can be driven by changing supply and demand, shifts in sentiment, or events that reduce the reasons for the earlier price surge.
- Knowing how to spot a correction in trading is not exact, but technical analysis can help by tracking price action around support and resistance levels. Traders may also watch related markets and common triggers such as economic updates, conflict, weather disruption, supply chain restrictions, and sharp moves driven by news or social media.
- How to trade during a correction depends on staying disciplined rather than reacting emotionally to short-term swings. A correction may be uncomfortable, but it is a normal part of trading and does not automatically invalidate a longer-term view.
- The main lesson is not to change course just because a correction has occurred. If you already hold a position, rebalancing may make sense only when market conditions or your risk strategy have changed; if you do not hold one, a correction can create a buying opportunity, though losses remain possible.
A correction in trading is when the price of a security drops by a meaningful amount in a relatively short period of time. A commonly used rule of thumb is a fall of around 10% or more from a recent high. This can unfold quickly or over several days or weeks.
It can be brief or extend over weeks (and sometimes longer), depending on market conditions. The point here is that a correction is deemed to have occurred when a security’s value declines by over 10%. You can see corrections as reset points and potentially profitable buying opportunities, as we’ll explain. However, note that prices can continue to fall during a correction, and losses are possible.
Why do corrections happen in trading?
Corrections can be caused by a variety of events, but the underlying reason sometimes comes back to the idea that an asset is overvalued. Why it’s seen to be overvalued will be a matter of market dynamics. For example, if you’re trading a commodity such as oil and a production shortage creates a bull market, a correction could occur when production levels return to normal.
Why? Because demand was outpacing supply when production levels were low. This made oil a more valuable commodity, which increased its value in a relatively short space of time. This increase could push the price of oil to an unusually high price.
However, once production returns to a point where supply and demand are in harmony, oil isn’t as scarce. So, the price can drop relatively quickly or, more accurately, it can drop to what might be considered a normal level.
Our example shows how a single issue can inflate the price of a security to the point its value is notably higher than previous trends suggest it should be. Then, once that event/issue has passed, the price corrects itself. These types of peaks and troughs can happen for a variety of reasons and to any security.
Quick summary: market corrections occur when something has caused the price of a security to buck recent trends and increase significantly before dropping back down to a more expected level.
How to spot a correction in trading
Predicting a market correction isn’t easy. They can and often will happen. Technical analysis can help uncover potential correction points by looking at current price data compared to support and resistance levels.
If a security keeps breaking through a resistance level but dropping quickly, the market could be bullish but volatile. These could be the ideal conditions for a correction.
Another way to look for possible correction points is to compare one market to another. For example, if you’re trading energy stocks and the price of oil suddenly drops, this could impact your stocks.
Another way to try to spot a correction is to look for triggers. Again, this isn’t an exact science. Something you might assume is a trigger may not cause a correction, but something unexpected could. However, certain events can cause corrections.
Some of the triggers you can look for are:
- Major economic updates, such as interest rate rises or new fiscal policies
- Conflicts, such as war
- Adverse weather conditions that can affect production chains
- Restrictions that can affect supply chain issues
- Mainstream news or social media activity can spike prices leading to a correction
Those are just some events that can trigger a correction. For example, if restrictions disrupt supply chains significantly, you may see stocks fall in value. It’s not guaranteed, but this is the type of thing you need to think about as a trader.
How to trade during a correction
A security’s price will always fluctuate. Therefore, as a trader, you need to be ready for the ups and downs. That sounds easy, but it’s not. Adjusting the psychological swings of trading takes a certain temperament. Learning to stay calm when markets are booming and falling is a skill.
A correction where the price of a security you’re trading drops 15% can be concerning if all you’ve ever seen are bull runs. However, as we’ve explained, these market movements are not only a natural part of trading but are common. The trick to trading through a correction is don’t panic. If your analysis suggests a security has long-term potential, don’t react to short-term swings by selling.
We’re not saying that it’s right to hold or sell. We’re simply saying that a correction shouldn’t blow you off course unnecessarily. This is where having a plan becomes important.
Analysing the market before you enter a trade is a fundamental skill you need to master. If you believe the value of a security will increase over 12 months, you may choose to hold.
This shouldn’t change just because a correction happens. There may come a point when you need to reassess and change your plan. This is called rebalancing. Rebalancing usually means adjusting portfolio weights back towards a target allocation. Market conditions can cause you to rebalance and change course. You might change course because you want to reduce your level of risk and a market correction doesn’t fit in with your new strategy.
Don’t change course just because of a correction
The main thing to remember is that you need a plan and corrections shouldn’t automatically change it. If the market or your personal preferences dictate that changing is necessary, that’s fine. Also, if a correction creates new conditions that mean changing course is probably a good idea, that’s also fine. What’s not fine is changing the course just because a correction has occurred.
That’s the thing to keep in mind if you’re holding a security. If you’re not, corrections can be an opportunity to enter a position. One way of thinking about corrections is that they’re a return to a state of normality, but you also know the security’s price has the potential to surge.
If you buy during a correction, returns could be positive if prices recover — but losses are also possible, including if the decline continues.
This isn’t guaranteed, but it’s possible. Trading during a correction is a matter of sticking to your plan if you’ve got a position, unless mitigating factors suggest changing course is wise. If you don’t have a position, market corrections can present potentially profitable opportunities to buy.