As we have seen in the past decade, bull markets can last for a long period of time.
But occasionally, a bull market will go too far ahead of itself and an unexpected slump in prices may happen.
When stocks or other financial instruments experience a sudden drop in the middle of a bull market, this phenomenon is known as a market correction because the prices are “correcting” back to the natural trend.
Here’s a closer look at how a market correction is defined and how it affects day traders.
What is the meaning of a market correction?
In financial markets, a market correction is generally considered to have happened when a major stock index, such as the Dow Jones Industrial Average or the S&P 500 index, drops by more than 10% (but less than 20%) from a recent 52-week high close.
While 10% is an arbitrary threshold in some ways, it often signals that investors and traders have turned more pessimistic about the market.
As we said earlier, it is called a correction because traditionally the decline often “corrects” and takes prices back to their longer-term trend.
Traders and investors commonly use this term to signify a market taking a breather, but not one in a coma. Think of a bear market as a hurricane, while correction would be a rain shower.
A bear market is a more severe and usually more continuous downturn in the market when stocks fall by 20% or more from a recent high.
The last bear market began on Feb. 19, 2020, during the onset of the Covid-19 pandemic, and lasted until March 23, 2020. Then, the S&P 500 plunged nearly 34% from peak to trough.
The previous bear market occurred during the global financial crisis. From the top of the market in October 2007 until the bottom in March 2009, the S&P 500 lost 56%
Why do market corrections occur?
Market corrections are usually caused by economic developments such as higher loan defaults or long-term unemployment.
In the case of a single stock, a correction could be as a result of a disappointing earnings report or another moving event.
If there have been changes that are weighing on the broader stock market, it may be a sign that you need to get ready for a prolonged correction that could even turn into a bear market.
After the economic shock or huge political developments that may have triggered a correction ends, the stock market generally recovers and continue inching higher.
How often does the stock market correct?
When the stock market keeps gaining steadily for a prolonged period, there comes a point when the term “correction” begins to float around on CNBC and other business news TV stations.
According to stock market research firm Yardeni Research, the S&P 500 has experienced 11 corrections over the past 21 years with only two of them turning into bear markets.
The last U.S. stock market correction ended in September 2020. The 2020 September market correction skimmed nearly 10% from the S&P 500 and more from the most stretched and biggest growth stocks due to fears over the spread of Covid-19.
For whatever reason, the ninth month is historically the worst month for the stock market by a huge margin. The S&P 500 has averaged a loss of 1% in September since 1928.
February and May are the only other months with negative average returns are -0.1% each. As a matter of fact, September is the only month that has had fewer (42) down years than up years (50).
What to do during a market correction
Nobody can forecast with any degree of certainty whether a correction will become a bear market or reverse. However, traditionally most corrections have not turned into bear markets.
But what if a correction is really the beginning of a bear market? Well, no bull market lasts forever and even though corrections and bear markets can be scary, day traders can expect them to happen once in a while throughout their lifetime.
Therefore, it’s important to use day trading strategies that potentially could benefit your emotional wellbeing and your portfolio in the event of a significant downturn.
Day trading during market corrections
Market corrections have little impact on day traders. If anything, corrections actually provide greater trade opportunities.
Keep in mind that market corrections bring volatility, which is characterized by wide price fluctuations and heavy trading. Volatility often results from an imbalance of trade orders in one direction (e.g. all sell and no buys).
Therefore, day traders should embrace corrections and look for short opportunities during these periods of downturns. If you are a day trader that likes to go long you can focus on
- Stocks that are dominating the news as their volatility is often enough to push through market downturns.
- Gold and other stocks that are related to precious metals
- Exchange-traded funds (ETFs) that are the inverse of the index
Here are two other important things day traders should consider when there is a market correction:
- Set up a trading plan. In day trading, one of the worst things you can do is try to trade without a well-laid-out plan. A trading plan acts as your guide and helps you plan a trade before you execute. It defines why you are making a trade and how you will execute it.
That’s why you need to have one and stick to it.
You don’t need a ton of time to create one, and there are a lot of potential benefits. A well-crafted plan can help you set up a well-balanced stock portfolio. It can also make it easier to stay the course and calm your nerves when the market is correcting or sliding into the bear territory.
- Evaluate your risk tolerance. Risk tolerance simply refers to your willingness and ability to stomach a loss when trading stocks or other securities.
While it is relatively easy to take risks when the market is on an upward trajectory, a market correction sometimes can be a wake-up call to consider reviewing your target asset allocation.
There is a certain level of risk that is inherent to the world of day trading. This risk level allows for the potential returns that probably got you into day trading in the first place.
When the market is correcting, it is advisable to determine how much loss you have the financial and emotional capacity to handle. Ask yourself how comfortable you will feel maintaining your positions when stocks are experiencing large drops.
Corrections are a normal part of the stock market, and the best thing day traders and investors can do during one is to stay the course.
Historical data shows that on average, market corrections result in a 13% slump and take about four months to regain their previous levels. If a correction plunges into a bear market, then there is a longer recovery time and more pain ahead.
Day trading when the stock market is correcting can feel like you’re trying to navigate through the wilderness. Worrying excessively about corrections and bear markets is counterproductive, but preparing for one is always a great idea.
The best thing is to stick to your trading plan and don’t let panic influence your decisions. And most importantly, keep in mind that your risk tolerance plays a vital role in your trading journey without worrying about it on a daily basis.