No financial market, including Forex market, can grow without a recoil for a long time. Inevitably on the chart will be formed "waves" against the movement, which market experts call the correction.
Correction is limited movement of prices against the main trend. The price seems to be adjusted to fair values, after rising too fast due to excessive customer activity. And in general, the upward trend does not stop.
Theoretically, a correction can be both a wave of decline in an uptrend and a wave of growth in a downward trend. However, in practice this term is more often used in a situation of an uptrend.
Causes of correction
Usually correction is preceded by a deterioration of sentiment. Optimism is replaced by anxiety due to possible problems, as a result of which purchases become more restrained, and sales gradually increase.
When the price reaches the maximum value for new customers, it becomes uncomfortable to enter the market, as investors clearly see the potential for a fall on the chart, but the growth potential is not so obvious. In addition, against the background of increased anxiety, even the smallest drawdowns can frighten investors and provoke sales from those who opened speculative positions for a short move.
Margin positions and stop orders
Investors who have bought close to asset highs have to be the most nervous, and the risk is not a reduction in profits, but significant losses. The situation is even more dangerous for investors who bought with borrowed funds. When prices begin to decline, such participants massively receive a margin call order from brokers, if they fail to comply, positions will be forcibly closed. This can lead to an avalanche effect when stocks/currencies/other assets are sold at any reasonable price, rapidly dropping quotes lower and lower. At the same time, the price may be at unreasonably low levels that do not reflect the real state of affairs.
Corrections can be not only for a single currency or a single stock, but also for the market as a whole. In the classical interpretation, market correction is defined as a decrease of more than 10%, but less than 20%.
In the modern world market, which demonstrates the longest uptrend in recent history, it was possible to observe eight corrections over 9 years.
A question may appear: “Why do investors sell for corrections, because the market will still recover later?”. The things is that during the correction often no one can reliably say what is happening. Is this another correction or the beginning of a full-fledged “bear market”?
Due to the complexity of market relations, it is often impossible to say for sure that the deterioration of macroeconomic indicators is the first sign of big problems or just a temporary phenomenon. In addition, problems that cause correction are often unique in nature and it is impossible to find an analogy to evaluate their significance. How will trade wars affect the market? How will “cheap money time” end for the global economy?
Different market participants adhere to different theories. However, after the first significant sales, most prefer to avoid risks and move into low-risk assets: currencies of stable states (dollar, yen), US government bonds (treasuries) or gold. As a result, mass purchases of shares are replaced by massive sales, and new investors try to stand aside and wait out the storm.
Features of an average correction
Market corrections are an integral part of investing and can make even the most experienced investors nervous. On average, a market correction happens about once a year. The average duration of the correction is about 71.6 days, during which the market loses about 15.6%. At the same time, the high level of pessimism in the media, which is full of terrifying headlines, is very characteristic of this phase of the market. You can also observe a strong discrepancy in analysts' forecasts and a high level of trading volatility.
Often, the correction involves two distinct waves, with the second sales wave usually stronger and deeper. This feature was noted at the beginning of the 20th century by Ralph Elliott, who presented his wave theory to the financial community.
The beginning of the correction is often preceded by a short consolidation near the maximum levels, when new buyers no longer come to the market, but sellers are still in no hurry to sell. Soon there is some kind of sudden event that plays the role of a kind of “trigger”, stimulating the first wave of sales.
The first wave of correction usually becomes a shock for market participants. Before it, investors didn’t particularly think about risks and considered mostly positive scenarios. Some players were locked in unprofitable positions, buying at highs. Investors, who were planning to sell large blocks of shares in the near future, are now beginning to actively look for opportunities to place their orders. A large volume of sales appears on the market, which expects suitable prices and sufficient liquidity.
At the same time, the reversal of prices from the highs creates attractive buying opportunities for those investors who planned to enter the market only after the drawdown. With the support of short-term speculators, they are beginning to gradually buy back the fall, raising the price higher within the second wave. Here too, a surge of growth is possible due to squeezing out of the players' positions for a fall, which are “short” at first wave minima.
However, we remember that first wave provoked a reassessment of risks in the market and now a large number of investors are in the “queue for exit”. With their sales, they hold back the recovery and at some point stop the second wave, reversing the short-term trend. At this point, competition among vendors begins to grow rapidly and the decline is accelerating. The investors that have just entered the position begin to “roll over”. Updating the minimum of first wave, causes massive triggering of stop losses. The situation is aggravated by speculators and trading algorithms, which lower their prices deeper with their “shorts”.
During this period, pessimism in the market reaches its maximum. Headlines in the media compete in eloquence, going through all the available synonyms for the word "disaster". Now no one is in a hurry to buy. The main liquidity for sellers is supplied by speculators who, at the first danger, leave positions, further increasing the imbalance. Volatility is high.
Redemption after the last wave is often sharp and swift. Usually on this day from the very opening, active purchases are observed, which raise the price from a minimum of 2-3 daily average ranges of the quiet period. Tensions in the market are gradually falling, and while part of the market is still extremely skeptical about the situation, the most agile investors are buying the depreciated assets with might and main, expecting a recovery in prices and fabulous profits.
However, prices are not always restored. How often does the correction turn into a full-fledged “bearish trend”?
In the period from 1980 to 2018, the US stock market experienced 36 corrections, of which only 5 grew into full-fledged “bear markets”, which brought many grieves to investors who were not lucky to be in long positions at those times. It turns out that about 86% of the reductions are normal corrections, and the market is successfully recovering in the future. But in the remaining 14% of cases, the fall is more serious and prolonged.
How to distinguish correction from market reversal
Probably many are interested, how can we distinguish the beginning of a long bear market from a correction? When does the market decline really mean that you should refrain from investing, and when does it represent an excellent opportunity for shopping at low prices?
As mentioned above, each situation is individual. But there are several key points that usually distinguish a temporary correction from a market crisis:
"Correction is largely caused not by actual problems, but by their expectations"
A distinctive feature is that the real problems that could lead to a fall in the value of assets have not yet occurred. The market is only waiting for them in the future, building forecasts on various indirect factors. At the same time, the market reacted to similar signals with much more restraint earlier.
Such behavior of participants may indicate that there is a psychological effect to a greater degree than real problems.
The factors that provoked the fall can be mitigated by the actions of the state or regulators
Correction of the US market at the end of 2018 occurred against the backdrop of escalating trade wars, expectations of rising interest rates and the suspension of the government. As a result, the Fed refused to raise the rate, the United States and China tried to conclude a trade truce that lasted until May, and the suspension of the government did not bring significant damage on the scale of the financial market.
Thus, if there is reason to believe that state administration bodies have at their disposal all the necessary tools to support the market, then most likely the current correction will not turn into something more serious.
Corrections often unfold, reaching the 200-day or 200-week moving average
During the corrective decline, a number of investors are closely watching the market and are waiting for the right moment to buy at attractive prices. However, fundamental analysis cannot answer the question of where a reversal may occur. Then technical analysis comes to the rescue. The 200 period moving average is a very common indicator among global investors to determine when to enter the market. It is most often used on the daily chart, however, with deeper falls, investors can focus on weekly timeframes.
Author: Kate Solano, Forex-Ratings.com