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Trading Skills & Essentials Risk Management


CORRECTION


By
James Chen

Full Bio
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James Chen, CMT is an expert trader, investment adviser, and global market
strategist. He has authored books on technical analysis and foreign exchange
trading published by John Wiley and Sons and served as a guest expert on CNBC,
BloombergTV, Forbes, and Reuters among other financial media.

Learn about our editorial policies
Updated February 17, 2022
Reviewed by
Michael J Boyle
Reviewed by Michael J Boyle
Full Bio
Michael Boyle is an experienced financial professional with more than 10 years
working with financial planning, derivatives, equities, fixed income, project
management, and analytics.
Learn about our Financial Review Board
Fact checked by Jiwon Ma


WHAT IS A CORRECTION?

In investing, a correction is usually defined as a decline of 10% or more in the
price of a security from its most recent peak.1 Corrections can happen to
individual assets, like an individual stock or bond, or to an index measuring a
group of assets. 



An asset, index, or market may fall into a correction either briefly or
for sustained periods—days, weeks, months, or even longer. However, the average
market correction is short-lived and lasts anywhere between three and four
months.2



Investors, traders, and analysts use charting methods to predict and track
corrections. Many factors can trigger a correction. From a large-scale
macroeconomic shift to problems in a single company's management plan, the
reasons behind a correction are as varied as the stocks, indexes, or markets
they affect.




KEY TAKEAWAYS

 * A correction is a decline of 10% or greater in the price of a security,
   asset, or a financial market.
 * Corrections can last anywhere from days to months, or even longer.
 * While damaging in the short term, a correction can be positive, adjusting
   overvalued asset prices and providing buying opportunities.

1:37

CLICK PLAY TO LEARN WHAT A CORRECTION IS





HOW A CORRECTION WORKS

Corrections are like that spider under your bed. You know it's there, lurking,
but don't know when it will make its next appearance. While you might lose sleep
over that spider, you shouldn't lose sleep over the possibility of a correction.



According to a 2018 report from CNBC and Goldman Sachs, the average correction
for the S&P 500 lasted only four months and values fell around 13% before
recovering.3 However, it is easy to see why an individual or novice investor may
worry about a 10% or greater downward adjustment to the value of their portfolio
assets during a correction. Many do not see it coming and don't know how long
the correction will last. For those who remain in the market for the long term
however, a correction is only a small pothole on the road to retirement
savings.4 The market will eventually recover, so they should not panic.



Of course, a dramatic correction that occurs in the course of one trading
session can be disastrous for a short-term or day trader and those traders who
are extremely leveraged. These traders could see significant losses during times
of corrections.



No one can pinpoint when a correction will start, end, or tell how drastic of a
drop prices will take until after it's over. What analysts and investors can do
is look at the data of past corrections and plan accordingly.




CHARTING A CORRECTION

Corrections can sometimes be projected using market analysis, and by comparing
one market index to another. Using this method an analyst may discover that an
underperforming index may be followed closely by a similar index that is also
underperforming. A steady trend of these similarities may be a sign that a
market correction is imminent.



Technical analysts review price support and resistance levels to help predict
when a reversal or consolidation may turn into a correction. Technical
corrections happen when an asset or the entire market gets overinflated.
Analysts use charting to track the changes over time in an asset, index, or
market. Some of the tools they use to determine where to expect price support
and resistance levels include Bollinger Bands®, envelope channels, and
trendlines.




PREPARING INVESTMENTS FOR A CORRECTION

Before a market correction, individual stocks may be strong or even
outperforming. During a correction period, individual assets
frequently perform poorly due to adverse market conditions. Corrections can
create an ideal time to buy high-value assets at discounted prices. However,
investors must still weigh the risks involved with purchases, as they could well
see a further decline as the correction continues.



Protecting investments against corrections can be difficult, but doable. To deal
with declining equity prices, investors can set stop-loss orders or stop-limit
orders. The former is automatically triggered when a price hits a level pre-set
by the investor. However, the transaction may not get executed at that price
level if prices are falling fast.



The second stop order sets both a specified target price and an outside limit
price for the trade. Stop-loss guarantees execution where stop-limit guarantees
price. Stop orders should be regularly monitored, to ensure they reflect current
market situations and true asset values. Also, many brokers will allow stop
orders to expire after a period.




INVESTING DURING A CORRECTION

While a correction can affect all equities, it often hits some equities harder
than others. Small-cap, high-growth stocks in volatile sectors, like technology,
tend to react the strongest.5 Other sectors are more buffered. Consumer staples
stocks, for example, tend to be business cycle-proof, as they involve the
production or retailing of necessities.6 So if a correction is caused by, or
deepens into, an economic downturn, these stocks still perform.



Diversification also offers protection if it involves assets that perform in
opposition to those being corrected, or those that are influenced by different
factors. Bonds and investment vehicles have traditionally been a counterweight
to equities, for example. Real or tangible assets, like commodities or real
estate, are another option to financial assets like stocks.



Although market corrections can be challenging, and a 10% drop may significantly
hurt many investment portfolios, corrections are sometimes considered
positive for both the market and for investors. For the market, corrections can
help to readjust and recalibrate asset valuations that may have become
unsustainably high. For investors, corrections can provide both the opportunity
to take advantage of discounted asset prices as well as to learn valuable
lessons on how rapidly market environments can change.


Pros

 * Creates buying opportunities into high-value stocks

 * Can be mitigated by stop-loss/limit orders

 * Calms overinflated markets

Cons

 * Can lead to panic, overselling

 * Harms short-term investors, leveraged traders

 * Can turn into prolonged decline




REAL-WORLD EXAMPLES OF A CORRECTION

Market corrections occur relatively often. Between 1980 and 2020, the S&P 500
experienced 18 corrections.7 Five of these corrections resulted in bear markets,
which are generally indicators of economic downturns.8 The others remained or
transitioned back into bull markets, which are usually indicators of economic
growth and stability.9



Take 2018, for example. In February 2018, two major indexes, the Dow Jones
Industrial Average (DJIA) and the S&P 500, both experienced corrections,
dropping by more than 10%. Both the Nasdaq and the S&P 500 also experienced
corrections in late October 2018.10



Each time, the markets rebounded. Then another correction occurred Dec. 17,
2018, and both the DJIA and the S&P 500 dropped over 10%—the S&P 500 fell 15%
from its all-time high.11 Declines continued into early January with predictions
that the U.S. had finally ended a bear market abounding.12



The markets began to rally, erasing all the year's losses by the end of January.
And by April 2019, the S&P 500 was up about 20% since the dark days of
December.13






ARTICLE SOURCES


Investopedia requires writers to use primary sources to support their work.
These include white papers, government data, original reporting, and interviews
with industry experts. We also reference original research from other reputable
publishers where appropriate. You can learn more about the standards we follow
in producing accurate, unbiased content in our editorial policy.

 1.  CFA Institute. "Rush Hour and Short Cuts: How to Navigate Market
     Corrections." Accessed Feb. 17, 2022.

 2.  Schwab. "Market Corrections Are More Common Than You Might Think." Accessed
     Feb. 17, 2022.

 3.  CNBC. "The Stock Market Loses 13% in a Correction on Average, If It Doesn't
     Turn Into a Bear Market." Accessed Feb. 17, 2022.

 4.  SEC. "Access to Capital and Market Liquidity." Accessed Feb. 17, 2022.

 5.  S&P Global. "Performance and Volatility for Sectors in the 2010s." Accessed
     Feb. 17, 2022.

 6.  Fidelity. "Consumer Staples." Accessed Feb. 17, 2022.

 7.  Yardeni Research Inc. "Stock Market Briefing: S&P Bull & Bear Market
     Tables." Page 4. Accessed Feb. 17, 2022.

 8.  Schwab. "Market Correction: What Does It Mean?" Accessed Feb. 17, 2022.

 9.  Invesco. "The Bare Necessities: A taxonomy of S&P 500 Bear Markets."
     Accessed Feb. 17, 2022.

 10. Nasdaq. "S&P 500 Joins Nasdaq and the Russell 2000 in Correction Mode."
     Accessed Feb. 17, 2022.

 11. The Washington Post. "Stocks Are Down After a Volatile Year, but That's Not
     the Whole Picture." Accessed Feb. 17, 2022.

 12. Nasdaq. "Stock Market News for Jan 2, 2019." Accessed Feb. 17, 2022.

 13. The Standard. "S&P 500 - 10 Year Daily Chart." Accessed Feb. 17, 2022.

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RELATED TERMS

Technical Correction Definition
A technical correction is a decrease in the market price of a stock, or index,
that is greater than 10%, but lower than 20%, from the recent highs.
more
Secular Market
In a secular market, broad factors determine the direction of an investment or
asset class over a long period of time.
more
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model is a model that describes the relationship
between risk and expected return.
more
What Is the S&P 500 Mini?
The E-mini S&P 500 is an electronically-traded futures contract representing
one-fifth of the value of the standard S&P 500 futures contract.
more
Bear Market
A bear market occurs when prices in the market fall by 20% or more.
more
What Is a Contra Market?
A contra market is one that tends to move against the trend of the broad market
or has a low or negative correlation to the broader market.
more

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