A reasoned trading plan can help you overcome your emotions and add discipline to your buy and sell decisions.
Understanding and Responding to Market Corrections
A market correction is something traders may not like to think about, but it’s something for which everyone should learn to prepare. A key to weathering – and potentially profiting from – a market correction is planning and implementation.
Predicting a market correction is far from an exact science. “If there were exact and clear-cut signs, everyone would be retired,” Brian Bachelier, vice president of active trader strategy at Scottrade, said. This doesn’t mean, however, that traders are flying blind if a market correction occurs. They should look for several factors that might foretell when circumstances are ripe for a correction.
Macro events are large-scale changes in economic indicators, such as an interest rate hike by the Fed, a monthly jobs report or changes in trade agreements.
“Unexpected events, whether decisions by central bankers that most people weren’t expecting, a change in a country’s leadership or a collapse of a nation’s economy, are likely to have the biggest impact,” Bachelier said.
Political uncertainty can lead to market volatility, both upward and downward. This can include terrorism, regime change in a developed country or rising tensions between countries. Negative headlines, however, don’t always necessarily lead to a market correction. Indeed, markets will occasionally rise in the face of negative news. What matters is the degree of uncertainty.
“The market reacts to uncertainty, and when anything creates uncertainty, the market tends to respond negatively,” Bachelier said.
Technical analysis is the study of price movements and trends to help provide traders guidance in determining when it’s optimal to enter and exit a market. It’s one of the oldest methodologies available, and, depending on the specific technique, relies on a series of data points related to price or volume movement on a chart over a given time period. Technical analysis can be applied to a single security, to sectors or to the entire market.
“From a trader perspective, technical analysis definitely plays a part because of how different markets and assets are correlated,” Bachelier said. “Employing technical analysis to spot trends can help confirm whether a market movement is temporary or more long-term and help people determine where they are in the current market cycle.”
Let a plan be your guide
Given the difficulty in assessing whether a market correction might be imminent, in the end the best plan is to have a trading plan in place. A plan can help you determine market points to either enter or leave a market, Bachelier said. Alternatively, it can help you decide whether to go short (profit from a market decline) or go long (profit from a market increase).
Part of your plan should also include keeping your emotions in check and ignoring hype that traditionally surrounds corrections. Financial media offer useful information about the markets, but during corrections, they can also feed the fear. Sticking to your plan helps keep your strategy in place.
Bottom line, Bachelier said, corrections often present traders with buying opportunities. “With a correction comes increased volatility,” he said. “With increased volatility comes opportunity, so traders typically try to embrace that.”
Next steps: For more information on preparing for extraordinary market events, read “Brexit: A Lesson in Diversification and Asset Allocation” and “Don’t Fear Market Volatility, Prepare for It.”
The analytical tools, examples and strategies described are for information purposes only and their use does not guarantee a profit. None of the information provided should be considered a recommendation or endorsement of any specific investment, tool or strategy. The choice to use a specific investment tool or strategy should be based solely on your research and evaluation of risks involved, your financial circumstances, and your investment objectives.
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