What is a technical correction?
A technical correction, often called a market correction, is a decline in the market price of a stock or index greater than 10%, but less than 20%, from recent highs.
It can also be applied to other securities or assets where the key characteristic is 10% to 20% against the previous movement.
- A technical correction is a decline in the market price of a stock, or index, greater than 10% but less than 20%, from recent highs.
- A technical correction can occur when the price of a security inflates too much in an uptrend, precipitating a selloff, or deflates too much in a downtrend, resulting in a buyback, when investor exuberance diminishes.
- Technical fixes are unpredictable, rarely lasting for a long period of time, but they do happen quite frequently.
Understanding of technical correctness
The term correction implies that prices may have been exceeded and should return to the market consensus on the value of that security, often denoted by its mean. A technical correction can occur when the price of a security inflates too much in a bull market, precipitating a selloff, or deflates too much in a bear market, resulting in a buyback, when investor exuberance diminishes.
Given that the current definition of a technical correction in the shares is that the price must fall, at least 10%, but not more than 20% that outlines a bear market, after a rebound in the price of that share, it is logical that this would fall within the realm of technical analysis.
Common characteristics of a technical correction include:
- They are unpredictable, rarely lasting for a long period of time, but they do occur quite frequently.
- While they are generally unwelcome to all types of equity investors, they are more of a concern to the short-term investor than the long-term investor.
- They can offer equity investors the opportunity to purchase quality stocks at discounted prices.
- They oblige all investors, especially long-term investors, to reassess the risk tolerance of their portfolio and make any changes they deem necessary.
Technical fixes can easily be mistaken for a possible rollback. Therefore, it is important for a trader to discern the difference between a correction and a reversal. There are many broad market factors that influence the value of a security and it may be important to follow along with the price of a security to identify a correction. Various studies and patterns have also been introduced to help the trader discern a technical correction.
Macro technical correction considerations
While technical analysis is based on following a security’s chart patterns for trading signals, there are still a variety of common reliable macro indicators that can be important to follow. Dow’s theory, introduced in the 1890s, also provides some basis for identifying technical corrections.
The Dow theory suggests that while markets experience trade volatility due to entrenched market-making processes that facilitate execution, security prices will follow some trend. This belief has led to the widespread use of engulfing channels, and specifically Bollinger Bands, to create trend lines of resistance and support around a candlestick pattern.
Surround channels are one of the most popular visual tools for identifying and understanding a correction. If a security experiences a significant change in the direction of a trend without the impact of a resistance or support line, a trader will generally look for macro factors to confirm that the change is a correction. One of the biggest macroeconomic factors is volume. Typically, a correction will occur at low volume, showing that there is no strong sentiment for the price. It is also important to check the security news to discern a technical correction. Since stocks typically trade with the trend, no significant announcements or major factors affecting a stock’s price can also help confirm a correction.
Technical correction patterns
As with other types of market movements, various patterns and technical analysis studies have been introduced to help support the identification of correction patterns for trading plans. Pullbacks and pullbacks are two common patterns that can help indicate a correction. Elliott wave theory is also a popular methodology that explains corrections through the use of motive waves and corrective waves.