A correction in the price of an asset is an unwinding move after a prevailing run higher. The strict definition of a correction is a price move that has unwound between 10% and 20% following a significant high. When the price falls more than -20% the move changes from being a “correction” to being a “bear market”.
Corrections can often be seen when the price has become overbought and a near-term bout of profit-taking is seen. This move helps to unwind an overinflated price and is often seen to be the precursor to the next bull run higher.
The strict definition specifying the -10% to -20% move tends to be associated more with moves in stocks or indices (assets where the prices will tend to trend higher over the long term). However, the term “correction” can also be more broadly applied to other asset classes such as forex and commodities. We can discuss “corrections” as simply near-term unwinding moves within a medium to longer-term bull market.
Technical indicators for a correction
Several technical analysis patterns and signals can signal the beginning of a correction:
- Shooting Star candlestick
- Hanging Man candlestick
- Bearish Engulfing candlestick
- Evening Star candlestick
- Dark Cloud Cover candlestick
- Double Top
- Triple Top
- Head and shoulders top
Here are a few techniques and studies that can indicate how far a correction will go:
- Uptrends – A near-term correction within an uptrend (bull market correction) will often find support around the uptrend before the bull run resumes.
- Moving Averages – In an uptrending market, the moving averages are used to define the strength and length of a trend. Moving averages work similarly to trend line trading.
- Relative Strength Index – In an uptrend the RSI indicator will tend to oscillate between 40 and 80. Moves above 70 may begin to generate the profit-taking that starts the correction. The correction then helps to unwind the RSI towards 40/50 and renews the upside potential.
- Bollinger Bands – unwinding moves in an uptrending market towards the lower Bollinger Band will tend to induce support and be the limit of the correction.
