Sunday, November 6, 2011

Friends request:What Is a Stock Market Correction?

Anyone who watches the stock market knows it doesn't move up or down in a straight line. Some days it's up; other days it's down. If you look at the bigger picture, however, you'll see that the market moves in trends--that is, it moves predominantly in a single direction over time. Within that larger trend, there will be periods when the market moves in the direction opposite the prevailing trend. Such moves are called corrections.
  1. Identification

    • A stock market correction is a temporary reversal in the major trend before the trend resumes. Though a market correction runs counter to the previously established trend, it doesn't represent the beginning of a new trend, at least so long as it remains a correction. A correction most often refers to a downward price movement after prolonged rallies, but it actually means a normalization of prices in either direction.


    • Stock market corrections occur when the investors and speculators driving a trend take profits. Most traders use comparison of risk and reward to evaluate the viability of any position. As a trend matures, risk begins to outweigh reward. Thus, a correction helps to tilt the balance back toward reward as prices return to more favorable entry levels.


    • In most cases, an individual stock or a broader market will use a correction to return to a support or resistance level. This can be a trailing moving average or a previous price point that served as a top or a bottom within the trend. In practical terms, ownership of shares changes hands from short-term investors--who ride a trend--to long-term investors who make acquisitions. This process is called moving from weak hands to strong hands, and tends to quiet volatility. Because the stronger hands are less likely to part with their shares, the correction (if downward) tends to fuel another rally as speculators try to again purchase shares but find themselves having to pay more.


    • Corrections are also called retracements because they move back over the same price territory recently covered by the major trend. One strategy of technical analysis focuses specifically on the extent to which a correction retraces the previous trend in order to gauge its progress. A minor correction retraces a little more than one third of the previous trend, while a larger retracement might cover a little more than two thirds. Fifty percent retracements are not uncommon, and are widely used to distinguish between major and minor corrections. A retracement of about three-quarters of a previous move is a very deep correction, and any more than that begins to suggest that a new major trend might have begun.

    Time Frame

    • Corrections are also evaluated in terms of their time frame, using the same ratios as described above for retracements in price. Retracements that are shallow in price tend to last longer in duration. Conversely, those that are deep in price seem to happen faster. By this logic, a deep correction that lasts as long as the previous trend can start to be viewed as a new trend. Shallow corrections of a very short duration probably wouldn’t be considered a correction at all.