A guide to trading stock market corrections

Stock market corrections can sound scary – but with preparation and research, they become just another part of the trading cycle. Here, we’ll talk you through everything you should know about a correction and how you can be ready when one hits.

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What is a stock market correction?

A stock market correction is a 10-20% drop in share prices from their most recent high. Market corrections can occur in a single stock, sector or across the entire stock market.

After a while, the market will reach a level at which the price is considered ‘corrected’ and buyers will re-enter. There’s no set rule for how long a correction lasts, but they’re typically considered short-term events.

You might also have heard that a market is entering ‘correction territory’. This is the description for intraday falls that don’t quite make the cut as full-on corrections. Usually, it’s because there’s a rebound before close – as is quite often the case.

This, for example, is what happened on January 24 2022. The S&P 500 fell more than 10% from its record set on January 3 in intraday trading amid panic over the economic recovery and falling corporate profits. But it rebounded before close and even ended with a slight gain. If the index had not rebounded, and closed lower, it would’ve been classed as a correction.

Correction vs bear market vs recession

While a market correction is a drop of less than 20%, a bear market is a more prolonged fall in prices of more than 20% from a recent high. While the two are very similar, bear markets last longer – they can continue for years but on average last 14-16 months.

Corrections are considered a natural part of the stock market cycle, whereas bear markets are usually met with more concern. Governments might even step in to stabilise a bear market.

Although corrections and bear markets can happen in a single asset, industry or market, a recession hits the entire economy. Recessions are more sustained downturns than corrections or bear markets, generally lasting for longer than 100 days. They also come with a downturn in GDP, income, employment, production and sales.

What causes a market correction?

A market correction can be caused by a number of factors. But broadly speaking, it occurs when a market reaches a level that is considered overbought. This happens due to irrational exuberance among investors.

When market participants are no longer willing to support the current price, they’ll close their long positions. The increase in selling pressure causes the market price to ‘correct’ to more accurately reflect the intrinsic value of the asset in question. At this point, the market regains its balance and buying increases again.

There are a lot of factors that can cause investors to sell. Here are a few common examples:

  • Political uncertainty and unrest
  • Earnings reports falling below expectations
  • Crises and unexpected economic events
  • Trade wars and economic sanctions

Ultimately though, the causes of changes to market sentiment depend on whether it’s a single stock, sector or entire stock market.

For example, for companies, earnings reports are the most common cause of corrections. But for the broader stock market, a correction is usually linked to a financial crisis – whether that’s sparked by interest rate changes, widespread sales declines or political tensions.

And usually, a correction across one stock market will have knock-on effects around the world.

How to know if a market correction is coming

Investors often assume a market correction is coming when share prices are high, inflation is rising and there’s slower economic growth.

But the reality is, it’s very difficult to tell when a stock market correction is coming. For the most part, you likely won’t know until it’s over. And if the market continues falling, it stops being a correction and falls into a bear market or recession territory.

Although it’s hard to tell when a crash is coming, that doesn’t mean you can’t get ready for it.

How to prepare for a stock market correction

How you’ll prepare for a stock market correction will be based on whether or not you’re a speculative trader or investor.

For investors, the best thing you can do is weather the stock market correction. The general trajectory of the stock market is up, so there’s little need for buy and hold investors to pay attention to these smaller corrections. Although they can provide the opportunity to buy stocks at the bottom of the downturn.

However, if you’re a speculator, price swings can create opportunities to profit from both the downturn and any subsequent bounce back. You can do so by using derivative products that enable you to trade without owning the underlying asset. Examples include CFDs, options and futures.

Here are a few things to bear in mind as you get ready for a market correction:

1. Focus on a few assets

It can be tempting to jump into every new trade you hear about, but without doing your research you’d be putting yourself at risk.

You might choose to short individual company stocks, if you’ve identified companies that will be particularly badly hit. For example, if you thought the travel industry could experience a downturn, you might short the shares of airlines, car rental companies or hotels. 

But the most common assets to focus on are indices and ETFs, as these enable you to trade a complete sector or group of stocks from a single position. For example, the iShares STOXX Europe 600 Travel & Leisure would give you exposure to companies from the European travel industry.

2. Build a trading strategy

A trading strategy informs how and when you’ll enter trades. Once you’ve decided on your asset, you’ll need to think about your profit and loss targets. You might simply say ‘I’ll sell oil at $89 per barrel and buy it back at $80.’, or you might have a more complex system of technical indicators working to show you when market sentiment turns.

It is important to be aware that most losses occur when you trade away from your strategy. Although it can be tempting to get swept along in the excitement of a correction, opening and closing positions based on fear or greed can lead to larger losses.

It’s best to stick the entry and exit points you’ve already set in place for yourself. And if you haven’t got a trading strategy yet, you can head over to our Academy to discover which is right for you.

3. Manage your risk

However, you build your strategy, it’s important to manage your trading risk. The most common way of doing so is using stops and limits.

If you’re shorting a market, you’d place your stop loss above the market price. Should your prediction of a market correction be false, your stop loss would close your trade out before you took on too much loss. You’d place it at a level where you’d be comfortable with the amount of risk you’re taking on.

You’d place your take profit at a certain level below the current market price, ready to take advantage of the downturn. As you’re assuming there is a ‘correct’ market price, this level is where you’d set your profit target.

It’s also worth ensuring the assets you do choose are diverse. By spreading your capital out across different markets and industries, you won’t be putting all your eggs in one basket. So, if the market doesn’t behave how you expected, you can avoid losing all your money in one fell swoop.

When was the last market correction?

The last market correction was from February to March 2020, which was brought about by the onset of the Covid-19 pandemic. The first correction occurred in the week starting February 24, when the S&P 500 fell by 12%. It was the biggest weekly decline since the 2008 financial crisis.

However, a lot of analysts wouldn’t class this as a correction, as there was an even deeper stock market crash to follow. The S&P fell by over 30% in total and didn’t reach its pre-crash price for over 100 days – which some class as a recession, or at the very least an economic contraction.

The previous correction was in 2018 when the S&P 500 fell into and out of correction throughout the last few months of 2018 before entering a full bear market on Christmas Eve.

List of stock market corrections

This table shows every S&P correction – a move of between 10-20% - from 1910 to 2018. The market crash of 2020, along with any other decline over 20%, has been excluded. It’s also important to note this is based on closing prices only, not intraday movements.

Year

Correction

Duration (in days)

1971

10.7%

103

1971

11.0%

76

1974

13.6%

29

1975

14.1%

63

1976-78

19.4%

531

1978

13.6%

63

1979

10.2%

33

1979

17.1%

43

1990

10.2%

28

1990

19.9%

87

1997

10.8%

29

1998

19.3%

45

1999

12.1%

91

2002-03

14.7%

104

2010

16.0%

70

2011

19.4%

157

2015

12.4%

96

2015-16

13.3%

100

2018

10.2%

13

2018

19.8%

95

 

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