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the anatomy of a stock market correction

Are you feeling fearful and apprehensive because of the latest stock market correction?

Did you sell at the lows and now regret it, or are you hanging on wondering if you should sell in case prices go lower?

Or did you jump in and buy at the lows?

If you're new to the markets, and have never been through a correction before, you probably realize by now that it can really be an overwhelming and fearful experience.

Watching the value of your trading portfolio decline suddenly, having your stops hit or finding yourself trapped in what you believe may now be a losing position, can really test your resolve.

The biggest fear with corrections though, is that you never really know if it'll to get worse and turn into a crash, or mark the start of a bear market.

It is this nagging fear that rattles the market the most and is the reason prices never recover immediately.

It takes time for buyers to return and confidence to build.

What you have to understand is that corrections of index's or specific stocks are a natural part of the market coming back into balance. One day falls can be scary but as you can see from the graph below, not uncommon.

Stock Market drops

They occur because the market or stock has over extended itself and it doesn't take much bad news or uncertainty to trigger one.

Fear and panic are much more powerful emotions than greed and so once a correction starts, stops get hit, margin calls get generated and there is a mad rush for the exits

Sellers leapfrog each others sell orders and in turn drive prices lower in their efforts to get out with at least some money left on the table.

The current correction has been caused by worries over China and some global markets that had become massively overextended. The US markets for instance, hadn't seen a correction since August 2011. All this has combined to produce the falls we have seen.

The fact is, that once markets or stocks for that matter gets too high, the smart money will start to distribute or build short positions in anticipation of a correction. This was what was going on from February this year where the US markets got stuck in a sideways range and couldn't make new highs.

When a market is poised like this after a long run up it doesn't take much to cause a panic selloff.

So what now?

All stock market corrections over time have actually always proven to be good buying opportunities. I have circled them in yellow and they can clearly be seen on the chart of the S&P 500's run up since 2009 below .

S&P 500

Most don't progress to being crashes or the start of bull markets, but this is always a possibility and so it does pay to be wary. You should always have good risk management practices in place.

​If we look at the statistics for the last 16 corrections on the US markets:

  • The average market drop was about 15%
  • It took on average 148 days to drop that amount
  • The average time taken for prices to recover back to where they were prior to the correction was 110 days.

So as you can see corrections nearly always take quiet a while to resolve.

Learn to be patient, don't expect that once you see the first automatic rally (nearly always seen after a selling climax) that the correction is over and that prices will immediately recover back to where they were before.

In most cases these initial rallies are the result of short covering and short term traders buying the "bounce".

The graph below illustrates how long it can take prices to break to new highs again after a correction. On average its about 3 months.​

Market recovery

It usually takes a few rallies and declines and further flushing out of weak hands before prices move back up in a major way.

In this post I'm going to show you just how this can play out.

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When is a correction over and what do we look for?

Technically a correction isn't over until prices move up above their previous highs and the initial trend continues.

Usually before that occurs there is a sustained period of sideways movement, within a fairly volatile trading range, and as this occurs we look for:​

  • ​Evidence that the market is building a cause for higher prices.
  • Testing for supply and signs of strength
  • Breaks of resistance and consolidation at support.
  • Accumulation

In these trading ranges, shorter term traders will buy and short sell, enjoying the volatility and the chance to trade within the smaller time frames. They help to define the price ranges as they buy and sell at support and resistance.

Larger players looking longer term will continue to accumulate, building their positions ready for the next move.

Weaker holders will capitulate and sell to these stronger hands. They are generally so spooked by the big falls and continuing bad news in the media they are just looking to get out at any cost.

The actions of the different groups of traders and investors with different time frames form these ranges and influence the structure of the market in ways that we'll look at in more detail in the next section.

  The 4 Main Types of Correction

Corrections occur in a variety of shapes and forms and most share some common characteristics. I've listed below the most common types that you are likely to come across, these are:

1. V shaped correction​

Prices plunge quickly and then recover to form a V shaped pattern.

v shaped correction

2. W shaped correction

Prices plunge sharply stage a rally that fails followed by a decline and then a recovery rally that forms a W shaped pattern.

w shaped correction

3. Triple bottom correction

Prices plunge sharply stage a rally followed by a decline, they then rally again which is followed by a second decline and then recover forming a triple bottom pattern.

There are a few variants of this pattern, the most well known being the head and shoulders pattern . This consists of 2 shoulders (s) either side of the main head (H) (see below).

Head and shoulders pattern

4. U shaped correction

This type of correction sees a decline that slows gradually then picks up speed again once it reaches the bottom forming a U shaped structure.

U shaped correction

So now we have some idea of what different forms corrections can take, let's have a closer look at what we can expect to see as a typical stock market correction progresses.

The following example is the 2011 correction on the Daily chart of the S&P500.

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​The Anatomy of a Stock Market Correction

The Waterfall Decline.

Usually once support breaks, on a daily chart, we'll get somewhere between 2-5 big down days with volume increasing as prices tumble. This is sometimes known as a "waterfall decline" for the obvious reasons.

As people panic and sell, the smart money will step in and buy in anticipation of higher prices later. This shows up on the chart as very high volume.

Stock market correction 1

We can clearly see this in the chart above and at this stage even though the market is nervous, the smart money will anticipate a bounce because they see it as being oversold and the chances of an automatic rally are high.

This is evident in the last widespread bar on the chart below (G) which dips down below the previous bar and yet closes on its high. Buyers have come in right on support.

The Automatic Rally

Stock market correction 2

We see an immediate rally known as an Automatic rally sometimes known as a suckers rally, dead cat bounce or bull trap. These rarely progress further than about 50% of the total fall down.

This then defines the upper boundary of the trading range that stocks will now trade in and we can see on the chart above that the price went sideways within this range for about 2 months.

It is very common to see the initial low broken during this phase, a move designed to "shakeout" the last of the weak holders.

Springing the Low

Stock market correction 3

When price dips down below the support offered by the preceding low and closes higher, we get what Richard Wyckoff called a "spring". This can also be viewed as a shakeout or a test for supply.

Buying this spring can be a very profitable low risk trade and is something I tend to actively look for.

This rally from the spring, usually forms the beginning of the new trend but of course this isn't confirmed until a higher low and a higher high are in place.

In this phase we see attempts to move higher and pullbacks usually on lower volume. In the example above this occurs back to the longer term trend channel demand line (green). Notice how light the volume is as well. Supply has dried up.

Testing Resistance

As the price rallies away from this low volume bar sitting right on support, prices rally and repeatedly test resistance.

Here we see, flags, pennants and triangle patterns forming. Higher lows and testing back into areas of potential supply occur as price prepares to break resistance and move higher as confidence returns.

Resuming the Trend

Once resistance (thick red line) is broken, the trend is ready to resume and usually does so at a pretty even and steady pace. There are occasional pullbacks and consolidation at various support and resistance areas, but the correction is now over.

Note that in the above example the market was trapped in a trading range for about 2 months. It took 5 months to break out of the triangle pattern that formed and almost 7 months to return to and break the previous highs.

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​Yes corrections can be scary and we can never truly know where they can lead. They can form the starts of bear markets and progress onto being a full blown crash but these are pretty rare occurrences.

This is why unless your time frame is short, you are experienced trader or you are able to trade the big swings and short lived rallies and declines, it's probably better to wait and be sure that the market is "building a cause" for higher prices.

Use the chart examples above as a general road map. Look for springs, take note of when the trend change is confirmed with higher lows and higher highs. Look for breaks of resistance and buy the tests on the pullbacks.

Learn to be able to read and understand the structure of the market.

Above all else, be patient and remember... corrections take time!

Thanks for reading my latest post. If you have got this far please take a couple of minutes to let me know how you fared in the latest correction. Did you sell, buy or sit it out and wait?

I'd really be interested to hear your comments.

3 Comments… add one

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3 comments… add one
chan wai on August 31, 2015, 15:19

how could we learn more on “spring” to determine market has turn.

Peter August 31, 2015, 16:21

Hi Chan, a spring may not always determine a turn in the markets but they do usually present a great trading opportunity. Confirmation of a spring would be a close higher the next day, if it moves too far though you need to wait for a low volume “test” and confirmation of that. It depends how aggressive you are, some traders will buy in towards the end of the session on a spring and set their stop loss below its low should it not follow through. If the spring is very high volume they have a higher chance of being tested too. I will put together a post just on trading the spring sometime in the future. Thanks for your comment.

Shaun September 25, 2015, 20:07

Awesome Peter, I should study and ingest your pearls of wisdom :).

With the current correction, I continue to accumulate.

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