What is a market correction

A correction is a sharp decline in the price of an exchange-traded instrument or market from a recent peak. All markets and trading instruments face a correction, be it stocks, cryptocurrencies, the S&P 500 or a commodity index.

In the stock market, a correction is considered to be a ~10% "pullback" in price, but no more than 20%. In the cryptocurrency market, the correction can be as high as 30-40%. In some cases, the "spread" is several hundred per cent.

There are two main types of stock market corrections - global and local. Global corrections are an integral part of the market cycle. They affect all correlated markets and can last for days or months. Global corrections are relatively easy to predict due to their duration. They give traders more time to make decisions.

Local corrections do not extend beyond a single market (or group of correlated markets). They are relatively short, ranging from a few hours to a few days. Therefore, local corrections are less predictable and are easier to panic during. Local corrections are also called market corrections on lower timeframes (for example, M30).

A correction is a natural part of any market cycle. It occurs because not everyone is willing to buy or sell the same market all the time. All participants need a "breather". This is especially true for large participants. After the accumulation, they must sell their assets gradually, piece by piece. Otherwise the market will be in chaos.

A correction is a healthy market reaction to periods of prolonged growth and increased "greed". All corrections are characterized by a steady decline in the price of an asset. But there is nothing "bad" about it. A market correction is akin to fatigue and muscle pain after a long workout - it is always followed by recovery. In the worst case a correction should be waited out, in the best case it should be used to average current positions or to open new ones.

Why corrections occur?

Market corrections can be caused by technical or fundamental factors. This is most often caused by market "overheating", when price growth exceeds "reasonable" limits. This makes market participants less confident about trading further. Most corrections have a similar "anatomy". Let us consider the basic technical and psychological aspects of the correction using the example of a bull cycle.

There are large and small players in the market. The big ones act rationally, building long-term plans and deal grids. They actually control the movement of the market. Any bull cycle follows an accumulation period. During the accumulation period, the big players gain their positions, building up the entry-exit grids at different price segments. As a rule, corrections occur in these segments.

The task of small participants is to recognize these plans and trade with them. However, it is often the case that small traders trade on reaction and emotion. Not everyone can anticipate the whales' plans.

Every market cycle has limits, they are set by the big market participants. For example, if at the beginning of a bull cycle the whales are fully confident of 3-4 weeks of steady growth, after those 3-4 weeks their confidence is noticeably lower (and gets even lower as time passes).

After a strong rise in the instrument, "early" investors start looking for exit points. But while growth is still underway, the market is still attracting new investors. At some point, market makers and bots get involved - they push the market even further, giving new entrants the illusion of unshakable growth by selling them more and more assets. These new volumes, injected on the optimism of small players, continue to push the market upwards. The more people make profits on market growth, the more it attracts the attention of new entrants. New investors buy up assets on the rush in anticipation of further growth. From this, the price of assets rises further.

At some point, the market "overheats" and becomes "overbought". Asset prices and stocks start to outperform their actual value. For example, if the "healthy" market price of a stock is $20, it trades at $40+ during a period of rapid growth. The market becomes a financial bubble. Throughout bull cycles, markets with strong correlation work almost like leverage - growing and profitable, they multiply each other's growth performance.

At some point, a 'ceiling' - local resistance - is formed. This is a price level that does not allow the price to pass beyond one point. It acts as a psychological barrier. Most active participants are not prepared to go beyond resistance, at least at this stage. This is especially true for large and early investors. It is usually their limit bids which form resistance.

A clearly delineated price peak emerges. It forces participants to consider how to proceed. Resistance poses a choice for investors: sell now or wait for a recovery. As many participants will inevitably start to sell, the price will gradually "slide" down from the peak. This will start to create even more price pressure, which in turn will provoke even more selling, etc. Resistance works like a "self-fulfilling prophecy" - people see this level and conclude that the price will not go past it, and sell from it. These sales set off a chain reaction, which leads to a correction.

Uncertainty and slight fear begins to prevail at the local level. Large participants keep and hedge their positions, while others sell them in a hurry, even at a loss. A short-term pullback in price emerges - this is a correction.

During the correction, everyone is closely examining the mood of other participants, especially the large ones. Everyone is trying to figure out what exactly is going on, and whether it is worth it to stay in the market further. Specifically, everyone is looking for a new "bottom". This is where participants are building their future strategies from. Large participants are scanning the market for threats of global declines. If there are none, there is nothing to be afraid of, the market just corrects itself. In this case, the big players put limit buy orders near the local peak. These bids form a new local level, which the price will hit, "probing" it - the bottom.

The bottom works as support. The level does not allow the price to fall further. The strength of the support is determined by the volumes of large bids. They must be large enough to prevent the market from buying them out quickly.

At some point the bottom becomes discernible, as does resistance before a correction. A typical local bottom is around ~10-20% of the pullback from the previous peak (or up to 30-40% in the cryptocurrency market). If the bottom looks strong, active participants will realize that the market is correcting. If the bottom is fuzzy, weak or gradually updating - there are fears that the market is about to collapse or go into a bearish cycle. The absence of a strong bottom can literally be construed as a lack of confidence by large participants in further upside.

New support is used to open new positions or add to existing ones. Confidence returns to the market. New volumes are "loaded" from the local bottom, which subsequently leads to a new growth cycle, and it leads to a new correction. The cycle repeats until the market goes into a sideways or bearish cycle.

The same logic applies to bearish cycles, but in a mirror image. No more or less stable market will fall forever. Sooner or later, even a falling market will have volumes flowing in (e.g. from short trading). After that it will start to correct upwards.

When will the correction end?

The problem with a correction is that it is difficult to understand in the moment that the market is correcting. Steady price declines are also inherent in collapses and bearish cycles. The big market participants and exchange bots have been working in more "sophisticated" ways in recent years. They do not make large bids all at once, but "throw" them into the market gradually, in small pieces. So they disguise their presence, so that other active participants could not see their plans ahead of time by their bids in the cup.

Therefore, for most participants the main problem is to make sure that the correction takes place. Any market correction, even if it started quite "harmless", under unfavorable circumstances can lead to the collapse or withdrawal into a protracted bear cycle. Let's look at the basic similarities and differences between a correction, a collapse and a bear market.

Corrections, collapses and bear markets

Corrections and collapses

Typically, market crashes occur in the tens of percent, up to 90-100 percent of the last peak. Collapses occur abruptly and relatively quickly. For example, within a day or two or a few days. Collapses are usually caused by major shocks or news. Corrections are more often caused by technical factors such as strong resistance levels, lower trading volume, etc.

Another important difference is market sentiment. Stock market corrections are cyclical and take place over several days or weeks. During a correction, the general market mood is more or less normal. A market crash causes widespread fear and can lead to panic selling. For example, the collapse of blockchain Terra and its token LUNA, the collapse of all assets of cryptocurrency exchange FTX, led to a massive cryptocurrency market crash.

Collapses are often followed by a bear market and a prolonged period of falling prices. If the collapse is global (across all key markets and indices), it is followed by a prolonged recovery, then growth. Collapses of individual assets and stocks are less likely to be accompanied by a recovery and may be irreversible. Corrections, on the other hand, can lead to a healthy uptrend.

Corrections and a bear market

A bear cycle can be defined as a sustained market decline of more than 20-30% from the previous peak (or more for the cryptocurrency market). A bear cycle is always triggered by global turmoil and crises. Prolonged corrections often raise suspicions that the market may go into a bear cycle. 20% of the last peak is an important psychological zone at which market participants "switch" from correction mode to bearish cycle mode. They start to doubt the correction, sell positions, and hedge. In other words, they save their assets.

A correction is a moderate concern about real-time events. While some emotional and short-sighted participants sell on panic during corrections, most large and experienced participants are confident of a recovery. A bear market is associated with deep and often hypothetical problems, such as a protracted economic crisis and general uncertainty about the near future.

During a correction, investors look at the market with optimism. Therefore, they return to it to buy at lower prices. This promotes recovery and further growth. A correction can turn into a bear cycle if more serious global factors - economic and political crises, sudden declines in other markets, etc. - affect the market. In a bear market, investor sentiment is much more pessimistic. Even after prices have hit global lows, participants are not sure they want to stay in the market.

Scalping corrections

Scalping is trading on "microscopic" price movements. Formations and movements scalpers deal with can be found in any market - bull, bear or during a correction. Technical aspects - liquidity and volatility - are important to scalpers. They can be found in any market phase. Corrections as such are therefore of little interest to scalpers. However, stock and cryptocurrency market corrections are also periods of ups and downs in liquidity. Therefore, scalpers should in any case pay attention to the current market phase in order to catch a wave of liquidity.

Conclusion

A correction on the market is a natural and expected phenomenon. Investors and traders know that corrections are inevitable, so they build their strategies taking into account their probability. In a sense, corrections "generate themselves". It is important for investors, intraday, medium-term and swing traders to examine the psychology and methods of large participants. Global corrections happen precisely at their beck and call. Either way, whether the market corrects or declines, it is essential to have a well-defined trading strategy and to adhere to risk management.