What are the characteristics?
Corrections in stock markets are interesting times for traders. Most experienced traders are completely out of, or shorting, in free-falling markets. They either have blanket rules for exit or they get stopped out of each of their positions as the market turns red.
Once in cash, these traders don’t sit relaxed. They keep on following their daily routine to identify turning points and hunt for the best candidates to trade when the markets stabilize.
However, there are unpredictable wait times when traders just have to follow their routines and not act, or act small to preserve their capital. Markets generally don’t go down all at once and there could be a few legs of downtrend before the market finally bottoms and reverses.
This is why corrections have to be handled carefully. You can always confuse an interim bounce as a reversal and it will come right back at you. If you are aggressive at such times, you could lose your financial and mental capital. You go through a few such phases and likely give up when the market actually turns.
(S&P 500 - Higher lows and break of resistance in July 2022, market bottom?)
How do corrections function
Markets go down in phases for varying lengths of time ranging from a couple of months to a few years, depending on the kind of excesses built, the reasons for the fall, and the support that the market is getting.
For example, the dot com bust lasted close to two-and-half years, while the global financial crisis fall lasted for a lesser time even when it was a much bigger crisis. That was because the Central Banks supported the markets with easy liquidity. How all the factors come together to move the markets is clear only in hindsight.
That said, tracking the news is not the best way to determine the correction bottom. Most of the time it takes hard work and needs analysing hard data like sentiment indicators, market breadth, and how individual stocks are performing.
At the trough, the sentiment is extremely bearish, breadth is tilted completely towards losers, the news is all bad and there are only a countable number of stocks trading above their long-term moving averages. Such extreme bearishness generally makes the bottom.
As the market turns, the bad news stops impacting the market, the breadth starts improving, and stocks reclaim their long-term moving averages but the market participants are still in disbelief.
All you have to then do is follow the data and turn off the news and hearsay. Data is the best indicator of the upcoming uptrend.
Follow the stocks and sectors
Some sectors and stocks refuse to go down with the markets in the later legs of the fall. They start to make higher lows when the markets are making lower lows, or they display extraordinary relative strength compared to the market and keep on hitting new highs when the market takes a breather from the fall.
For example, below is Amazon’s chart from 2002. The stock price (candle chart) of Amazon bottomed before the market and did not hit a new low as the Nasdaq Composite (Orange line) hit a new low. Amazon went on to deliver 250%+ returns in a year after the market bottomed, while the NASDAQ delivered 75% return.
If you see many stocks displaying such characteristics, it’s an indication that the downturn is losing steam.
Apart from looking for such behaviours, look for stocks that are hitting new highs and for sectors or groups these leading stocks belong. If there are stocks and sectors that are making newer highs before the markets, those can very well be your winning set of stocks to play the first leg of the uptrend.
Some of these sectors will start performing right away after the weight of the market is lifted, while some will set up later and move fiercely while the market is still stabilizing.
All you have to do at this point is to keep track.
Once you have enough sectors and stocks displaying constructive price behaviour, you can get ready to act big and make the most of the move.
Take progressive exposure
If you see tradable opportunities after the market bottoms, you must not get all in. Instead, you must take progressive exposure starting with a small part of your capital to test the waters. If those small positions start working, you may progressively increase exposure and gradually move to be fully invested.
Alternatively, if the positions don’t work, you must not increase the exposure and keep trading small until you see trades working.
Look for low risk entry points
You must always look for entry at points where the risk is small and you lose a small sum when you get stopped. That way even if you get stopped a few times in a row on small exposure, you wouldn’t lose too much of your capital and you wont need huge gains to recover.
(Don't let the losses grow)
For example, as of today (July 2022) I'm using 10% position size, and if my average stop loss is 10% I would only be risking 1% of total equity. Too big a position size and/or too big a stop loss and testing the waters could be very expensive.
The idea is to not lose your bull market gains in corrective markets and preserve your capital. You must keep following stop-loss discipline at all times irrespective of how strongly you feel about the opportunities and the set-ups you are trading.
The Final Word
Bear markets or corrections can take an emotional toll on the trader’s mindset, which will make you do dumb things at the worst of times. This is why it’s essential to go slow and lose less to maintain sanity.
The markets present many opportunities each day and, as a trader, you must preserve your financial and mental capital to benefit from these opportunities as and when they come. Trading systematically with discipline is the best way to maintain longevity in trading. That’s what every trader should strive to do.
Remember, market drawdowns eventually present potentially life changing opportunities when they turn, just be ready for when they do.
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