Stock market corrections

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.

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.

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. Read more about event-driven trading​​.

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.

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.

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 spread betting or trading CFDs, which are derivative alternatives to investing in physical shares. In particular, spread betting is a tax-efficient* way of speculating on the price movements of the underlying assets, and 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 spread bet and trade CFDs on our award winning** Next Generation trading platform by opening an account.

Remember that heavy shorting activity can lead to a short squeeze in the stock market, which is a very risky position to enter. Learn about short squeeze indicators​ to look out for.

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 spread bet and 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​.