A market correction occurs in a situation when the price movement of a financial security, such as a share or a stock index, experiences a rapid decline from a peak, by a minimum of 10%. After a period of time, the decline is halted and the market regains its equilibrium. This article focuses on stock market corrections in particular, and describes how and why they can happen. A stock market correction can be disadvantageous to some traders whereas others may seek to benefit from them. Read on and learn about its causes, real life examples, and how traders can prepare for and trade a stock market correction with derivatives on our Next Generation CFD trading platform.
Stock market correction meaning
A stock market correction occurs when the price movement of a share or stock index that tracks the performance of multiple shares experiences a rapid decline. This transpires when the losses affect an entire market. Strictly speaking, no set amount of loss defines a market correction, but the accepted amount is a decline of 10%.
Analysts usually consider market corrections to be short-term situations but do not define a certain amount of time. It has been given the term ‘correction’ because once the market recovers from the decline, the prices then reflect the accurate value of the underlying assets. Unlike market manipulations, stock market corrections happen naturally and are not driven by investor intent.
The differences between corrections, bear markets and crashes
Market corrections can - but should not – be confused with a bear market. They are very similar in the sense that in both scenarios, the market suffers a steep decline. However, whereas market corrections tend to only last for a few weeks or months, bear markets can often continue for several months or years.
The amount of loss is another difference between the two. A bear market requires a minimum of 20% loss in value, whereas a market correction is a minimum of 10%. A stock market correction is generally deemed less of a threat than a bear market, so the actions that organisations and governments take to battle a bear market are far more drastic than that of a market correction scenario. Additionally, stock market corrections often occur more frequently than a bear market.
When the market falls quickly and deeply – such as a fall of more than 10% in a day, it is called a crash. This usually occurs during – or causes – major disruptions to the economy and are often followed by a recession.
Causes of a stock market correction
A stock market correction can occur from a situation of irrational exuberance. This is when the stock market is showing an uptrend and traders are highly confident that the price of a share, or multiple shares, will continue to rise. However, the underlying value becomes an oversight, and the asset’s price outstrips its underlying value. Consequently, the price movement will drop and the steep decline will continue for a period of time. Eventually, when investors begin to sell their stocks, a correction occurs. The market regains its equilibrium, creates a balance of supply and demand, and re-establishes itself. Buying rates increase again and prices are restored to its appropriate level.
There are many other factors that can cause traders to panic and rapidly sell their assets, which can ultimately lead to a market correction. These include situations of political unrest, trade wars, a global pandemic and economic downturn.
There is no way to predict when a downturn will start, end, or tell how drastic of the price drop will be until it’s over. However, analysing past instances can help investors plan for the next inevitable correction.
Major market downturns throughout history
There have been many significant market downturns throughout history, going back as far as 1637. Looking at some of the biggest events we can gain insight into the triggers for these events, but more importantly, we can get an idea as to how the market recovers.
US Stock market correction 2018
In 2018, between September and December, America’s S&P 500 index experienced a correction after plummeting into an all-time record decline. Among several causes, a factor that contributed to the market correction was the intense scrutiny that the major technology companies came under. Facebook, Apple, Amazon, Netflix and Google – together known as FAANG stocks – can have a significant influence on the performance of the S&P 500. When performing well, they can elevate the S&P 500 overall and the opposite can occur when experiencing a dip in performance.
The five tech giants came under a great amount of scrutiny due to reports of mishandling private data. The pressure mounted not just from the regulators, but also from the lawmakers. Twitter, Google and Facebook were scrutinised by Congress for not taking enough action on preventing the spread of disinformation from Russia during the 2016 election. Apple came under further scrutiny amid their Supreme Court trial of Apple Inc. vs Pepper, which was a lawsuit based on antitrust allegations. Additionally, pressure mounted on Amazon due to a series of Tweets from the then-President of America, Donald Trump, which involved allegations that Amazon were avoiding tax and not paying fair rates to the US Postal Service. These issues played an influential role in the downturn of investor confidence, which ultimately contributed to the S&P 500 index plummeting before the correction took place.
Wall Street Crash of 1929
The Wall Street Crash of 1929 had a huge impact on the global economy and marked the start of the Great Depression. After the rapid economic expansion of the 1920s, growth had slowed significantly towards the middle of 1929 in the US. As production declined and unemployment rose, the market adjusted, and by October 29, the Dow Jones had fallen 12 percent. It remained on a downward trend until it finally reached a bottom in 1932. The Great Depression affected every Western country and prompted much government intervention. Most notably in the US, President Franklin D. Roosevelt launched the New Deal, an ambitious attempt to stimulate the economy and create jobs. The market had recovered significantly after four-and-a-half-years and within 25 years, the Dow Jones Industrial Average had recouped its losses.
Black Monday
On Monday October 19, 1987 stock markets all around the world collapsed, with some falling as much as 23 percent in 24 hours. While there were a number of contributing factors, the crash was exacerbated by flaws in recently introduced computer trading systems. At the time, systems would automatically sell stocks when a specific loss target would be reached, meaning prices were pushed down and a domino effect started, sending markets into a downward spiral.
Despite the dramatic scale of the fall, the market didn’t take long to recover. After central banks cut interest rates, financial markets in the US and Europe fully recovered, and by the end of the year the Dow Jones had risen by 15 percent.
Global Financial Crisis
The years leading up to 2007 were a strong period for the global economy, particularly the US. With interest rates, unemployment and inflation low, housing prices were on the rise. With the expectation that this would continue, US banks were willing to make increasingly large volumes of risky loans. As house prices began to fall, the share of borrowers that failed to make their loan repayments began to rise. Banks incurred huge losses as the repossessed homes could not be sold for a price that would balance out the loan. As US banks had interests in other countries these effects of this crisis spilled over into other markets. However, governments were quick to intervene, and issued stimulus packages and interest rates cuts to stimulate consumption and investment. With all these measures in place, markets managed to bounce back by 2009.
How to prepare for a stock market correction
There are actions that traders can take that may help them in the lead up to, and during, a market correction. A stop-loss order helps to manage risk by closing you out of your position once an asset reaches a certain price, and aims to cap the amount of potential loss on a position. Therefore, this may come in handy when dealing with falling equity prices as the market begins to decline, and to limit potential losses.
It is important to have a trading plan where you can map out trading strategies. As the stock market begins to decline and a correction is predicted ahead, it is beneficial for traders to have an idea of which positions to hold in the long or short-term. This may prove useful when making decisions as the market changes in order to react in the most rational and logical way. Understanding the long-term impact of a decision is integral. Reacting in a state of panic can potentially be damaging, rather than acting rationally and aiming to benefit in the long-term.
Investing during a market correction
There are some investors who view a market correction as an opportunity for gain. They may look for lower share prices with the aim to profit when the market reaches an equilibrium and recovers.
In a stock market correction, other investors look to trade on less volatile assets, like consumer-staple stocks. This is because they are often thought to be more stable during a correction, rather than small-cap stocks within volatile industries. Therefore, traders may seek to trade on stocks of companies who deal with essential and every-day produce. Examples include large-cap or blue-chip stocks, which are seen by some investors as more reliable and stable within the stock market. However, as explained previously, this may not always be the case and these types of stocks can still result in losses.
Many shares lose value in a market correction and traders may look to profit by shorting the market. This strategy can be achieved by way of trading CFDs, which are derivative alternatives to investing in physical shares. In particular, CFD trading allows traders to buy or sell a number of units for an instrument, with the difference in price being exchanged at the end of the contract.
Until the market recovers, traders may aim to profit by way of shorting stocks with derivative products in order to reduce the losses from shares investments that they wish to keep open. You can trade CFDs on our Next Generation trading platform by opening an account.
Trading a market correction with CMC Markets
In summary, a market correction occurs when price movements of instruments experience a rapid decline until the market regains its equilibrium. Market corrections can result in negative consequences for some traders, whereas others may try to benefit from the market decline. Using our platform, traders can trade CFDs on declining share prices by opening an account with us today.
Our Next Generation platform also consists of a variety of useful features such as the news and insights section, which contains fundamental analysis stock reports from Morningstar and news updates from Reuters. Explore more of our platform features through our library of platform video guides.