Posted On 05 Mar 2020
To understand what market correction is, it is important to see the trading arena for what it is; it is a market place. In any market place, prices and the value of goods will change, depending on the supply and demand.
Now in some cases, the goods will be priced high in the market, and this is usually when the supply is low but the demand is high.
After the event of people buying (high demand), the market could correct itself by shifting the demand lower, thus creating an oversupply, which will then drive prices down. This is a simple example of what happens in a market correction, except in the world of stocks, you are looking at stock value and the overall index and not just tangible and concrete consumer goods.
Strictly speaking, a market correction is a decline by 10% in a stock, bond, commodity or index. This usually happens as a natural correction to overvaluation. Usually marked by a reverse movement, corrections are generally temporary price declines interrupting an uptrend in the market. It is a price decline that ends an upward trend. While it may seem like an alarming phenomenon, especially to first time traders, it is actually a very normal one.
It was mentioned earlier that a market correction happens due to a possible overvaluation of several stocks. Possible explanations for this overvaluation could be a strong anticipation of perceived gains by a group of investors. This will lead them to buy into a trend, and then the price would increase. From there, the buying will slow down and the price will fall (pretty much like the example in the first paragraph), this is when we see the decline in the stock price. This is a market correction in action.
Should you worry whenever the market corrects? No. This is a normal way for the market to correct itself. It actually shows the true market value of the stock. During this time, some traders will buy when prices are lower. Some investors look at it as a necessary evil so an over-valued stock will return to its real value.
For example, last year in October, the US market underwent correction. This created a lot of anxiety and fear in investors as they saw the index go down. By the end of the year the total index was at +13.85%. So, the market correction does not necessarily spell doom. It can, however, incur some costs on you if you are not careful. What this usually means is you end up trading out of speculation and fear and end up losing, i.e. converting your paper losses to actual realized losses when you decide to sell a stock at a losing price.
It pays to know the difference between unrealized and realized losses. An unrealized loss is a paper loss. This is the difference between the price of a stock when you purchased it and its current price. A realized loss is an actual loss. It is the difference between the price of a stock when you purchased it and the price when you sold it. During a market correction, you can shield yourself by being vigilant about your unrealized losses.