Technical Correction: What it is, How it Works

What Is Technical Correction?

A technical correction, often called a market correction, is a decrease in the market price of a stock or index that is greater than 10%, but lower than 20%, from the recent highs. It can also apply to other securities or assets where the key characteristic is the 10% to 20% counter to the prior move.

Understanding Technical Correction

The term correction implies that prices may have overshot and need to revert to the market consensus of that security's value, often denoted by its mean. A technical correction can occur when a security's price gets overinflated in a bull market, precipitating a selloff, or overly deflated in a bear market, resulting in a buyback, when the extremes in investor behavior, whether that's exuberance or panic, wanes.

Given that the current definition of a technical correction in stocks is that the price must decline, at least 10%, but no more than the 20% that delineates a bear market, following an upswing in that stock's price, it stands to reason that this would fall into the realm of technical analysis.

Common characteristics of a technical correction include:

• They are unpredictable, rarely last for a prolonged period of time, but occur more frequently than reversals.
• While they are usually unwelcome to all types of equity investors, they are more worrisome to the short-term, rather than the long-term, investor.
• They can offer stock investors the opportunity to pick up quality stocks at discount prices.
• They force all investors, especially long-term investors, to reassess their portfolio's risk tolerance, and make any changes that they deem necessary.

Technical corrections can be easily confused with a potential reversal. Thus, it is important for a trader to discern the difference between a correction versus a reversal. There are many broad market factors influencing a security’s value that can be important to follow in conjunction with a security’s price to identify a correction. Several studies and patterns have also been introduced to help a trader discern a technical correction.

Macro Technical Correction Considerations

While technical analysis relies on following chart patterns of a security for trading signals, there are still a variety of reliable common macro indicators that can be important to follow. The Dow Theory, introduced in the 1890s, also provides some basis for technical correction identification.

The Dow Theory suggests that, while markets experience trading volatility due to the ingrained market-making processes that facilitate execution, security prices will follow some trend. This belief has led to the widespread use of envelope channels, specifically Bollinger Bands, for creating resistance and support trendlines on chart patterns.

Envelope channels are one of the most popular, visual tools for identifying and understanding a correction. If a security experiences a significant change from the direction of a trend without the impact of a resistance or support line, a trader will typically look to macro factors to confirm the change is a correction. One of the greatest macro factors is volume. A correction will typically occur with low volume, which shows that there is not strong sentiment for the price. News about the security is also important to review for discerning a technical correction. Since securities typically trade with trend, no significant announcements, or important factors, affecting a security price can also help to confirm a correction.

Technical Correction Patterns

Similar to other types of market movements, several technical analysis studies and patterns have been introduced to help support the identification of correction patterns for trading plans. Throwbacks and pullbacks are two common patterns that can help indicate a correction. Elliott Wave Theory is also a popular methodology explaining corrections through the use of motive waves and corrective waves.