What is a market correction and what to do when it occurs

Corrections regularly occur in financial markets, especially in cryptocurrencies. Every crash starts as a correction, but not all corrections lead to crashes.

In this article, we will discuss what a market correction is, what happens during a correction, and what to do to prepare for it.

Understanding Market Cycles

Market cycles are the bullish rallies and bearish corrections in all financial markets. In general, markets never move in a straight line, as there is an ebb and flow, a return and a bounce in prices that shake out weaker holders.

Market cycles have existed since the beginning of trading, and this phenomenon continues with Bitcoin and other cryptocurrencies to this day.

The market cycle begins with the hope that prices will rise. Often this is accompanied by strong fundamentals, or the asset is not widely known for early adoption.

As prices rise, the mood changes to euphoria as we begin to believe that we are the geniuses who figured out the market. At this point, complacency sets in and the market is no longer valued.

The market correction begins, and at first, investors believe that this is just a failure in the overall uptrend. However, when this correction turns into a bear market, anxiety, denial and panic set in.

These emotions can be strong, leading traders to close their positions when they have already suffered serious losses.

After that, there is usually a bounce, and traders are angry that they closed positions at the most inopportune time.

These emotions are typical for both the stock market and the cryptocurrency market. The biggest difference is that the volatility in the cryptocurrency market amplifies these emotions.

What is a market correction?

A market correction is a decrease in the price of an asset or financial market by ≥ 10%. A correction can last any amount of time, from a few hours to months or even years.

The drop is called a “correction” because it is fairly small, and usually indicates that the cryptocurrency has deviated too far from its established trend. Corrections are more common in the crypto market than in the stock market, and can occur within a few hours due to the volatility of cryptocurrencies.

Corrections are usually followed by recovery, but they can lead to more pronounced downturns, known as bear markets.

Market Correction vs. Bear Market: Differences

Bear markets are larger market corrections, with declines of 20% or more.

It is believed that the bear market got its name from the way the bear attacks its prey by lowering its paws. As a result, bear markets are synonymous with down and falling prices.

The biggest difference between a market correction and a bear market is the depth of the fall. With a shallow market correction, the fall will be 10% or more. However, if the fall is deeper, by more than 20%, then this is no longer a correction, but a bear market.

What Happens During a Market Correction

The most obvious result of a market correction is a price adjustment to lower levels. For various reasons, traders and investors feel that current prices are too high and not worth the risk of tying up their capital.

As a result, current investors decide to sell all or part of their shares in order to take profits. New investors considering a purchase put their investment aside in the hope of acquiring it at a lower price in the future.

Falling prices for cryptocurrencies are beginning to attract more and more buyers. These investors are interested because they previously thought prices were too high. Now that prices have declined, they have an incentive to make their investment, and the price recovers in a rally.

What triggers the correction

The list of reasons why a market correction begins is potentially quite long and controversial. Not every analyst will agree on why a correction is unfolding, and the reasons are not always obvious.

In many cases, the emergence of new, negative catalysts can provoke investors to sell. For example, rumors of a possible outbreak of war or the declaration of a pandemic can scare investors into selling.

Note that rumors are often the catalyst. In March 2020, a pandemic was announced and the market crashed. As reality became reality, political leaders took action and shut down their economies to keep people at bay. At this point, the markets recovered even though the economies were just beginning to shut down. Correction usually starts on rumors (pandemic announced, various unknowns) before action occurs (the economy will be shut down).

Other correction catalysts may be fundamental, such as a slowdown in economic growth or the end of monetary easing. Without an influx of additional discretionary money, investors will have less funds to trade cryptocurrencies.

Sometimes the market corrects for technical reasons. For example, if the rally drags on, investors may like the project but not the current price. So they hold back their investments and the market corrects.

Finally, market sentiment can signal an upcoming correction. When a rally lasts for a while and then prices accelerate even further, this can be a sign of too much enthusiasm, which alerts whales and smart money to start selling.

A bullish rally requires an increase in the number of buyers. Only sellers or no buyers are needed for correction. When prices stretch, buyers shun and sellers are motivated, resulting in a correction.

How long does the correction take?

A correction can last for any length of time, from minutes and hours to months and years. Ultimately, it is more about the depth of the fall than the time spent in correction.

Since corrections are relatively shallow, their duration is usually relatively short. It is not unusual for the cryptocurrency markets to change by 10% or more in a week (and sometimes in a day!)

When the market starts to decline, it falls further and further from its high. Eventually, a low is formed and the market begins to rise again. We won't know for sure when the correction will end until the price hits a new high.

However, technical analysts are looking for signs that the correction is over and a rally to new highs is beginning. Analysts use chart patterns such as triangles and wedges in conjunction with Japanese candlestick patterns such as bullish engulfing or harami to signal the potential start of a new trend.

What should be done during the correction period?

At the most basic level, market corrections occur because investors and traders are more motivated to sell than to buy. Every decline begins as a correction. However, we don't know (until we know) whether the correction will escalate into something deeper, such as a bear market or a crash.

Therefore, it is important to manage trades before the correction occurs and after it begins. Here are three strategies to help you gain perspective and action during a correction.

Trading Strategy 1: Eliminate Risk

The first strategy is based on preparing for a correction. If you see signs of a developing top in the cryptocurrency markets, such as bearish candle formations or downward reversal of oscillators, then consider cutting your long position.

The fastest and easiest way is to sell all your positions.

For example, a Bitcoin trader may notice a bearish divergence on the charts. Bitcoin price continues to make new highs while the Relative Strength Index (RSI) oscillator makes a lower high.

This behavior suggests that the market may correct down.

If a trader notices this on their chart, they may decide to close their long Bitcoin position. Another option is to close only part of their position to preserve their Bitcoin investment if the price continues to rise.

Trading strategy 2: Buying dips

If the first strategy prepares for a correction, then the second technique is aimed at actions after the start of the correction.

As the cryptocurrency market begins to correct downwards, technical support levels will begin to break. Generally, long-term support levels hold up better than short-term ones. So when the market corrects, identify these long-term support levels on your chart and use them as a buying opportunity on the correction.

As bitcoin rose in late 2020 and early 2021, there were times when a correction temporarily consolidated these gains. A trader can use long-term trend lines or, as in the case of Bitcoin above, a moving average to identify a strong support level.

The chart above is a 50-period exponential moving average (EMA). The moving average calculates price data for the last 50 days (to determine this average price). When the market is well above the line, the EMA suggests that Bitcoin is overheated and a correction is brewing. When Bitcoin returns to the 50-period EMA, it shows that its price is more fair.

Therefore, a trader can open new buy positions at the level of the longer-term moving average when there is a correction.

Trading Strategy 3: Cost Averaging

The third strategy, cost averaging, is designed for those traders who are just starting to read charts. This strategy will help them maintain long-term investments without leaving good positions.

When you trade cryptocurrency, volatility can flare up without warning and wipe out the floating returns you've been making. Dollar Cost Averaging (DCA) is the solution to volatility.

DCA is a way to split your overall investments because it initiates regular systematic entries. With DCA, you can reduce the impact of price volatility because sometimes you will buy at higher prices and sometimes at lower prices.

For example, let's say an investor has $5 that they want to invest in Bitcoin because they believe that BTC has a lot of upside potential.

They want to spread out their investment over time, so they decide to invest $1 on the first of the month for five months in a row. That way, they'll buy $000 worth of Bitcoin every month — no matter what the price is. Here's a summary of their purchases.

Date	Investment Amount	Bitcoin Price	bitcoin bow
April 1, 2021	$1,000	$58,788	0.01701
May 1, 2021	$1,000	$57,889	0.01727
June 1, 2021	$1,000	$36,674	0.02726
July 1, 2021	$1,000	$33,512	0.02984
August 1, 2021	$1,000	$39,833	0.02510
Total	$5,000	$42,925 average	0.11648

Note that this trader's average entry price after five months is $42. This figure is only slightly higher than the price of bitcoin on August 925, 1.

The five months of DCA above occurred during a severe bear market that wiped 50% off the price of Bitcoin. A trader with a one-time investment of $5 near the high could have lost 000%. A trader with DCA lost about 50%. This is a great example of how DCA can smooth out price volatility so that each correction becomes less painful. Corrections become less painful over time – because you can buy more coins at a lower price.

What to do if the market continues to collapse?

Cryptocurrency market crashes are common and normal. If the market is crashing, the best thing you can do is stay calm. If you had a trading plan before the crash, then follow it. For example, if the plan calls for DCA and buying at a lower price, then act accordingly.

If you don’t have a plan and you feel yourself getting emotional when prices fall, remember that after all crypto crashes there is a rebound. This doesn’t mean that prices will always recover. However, one of the main effects of a crash is that weak hands are forced to sell their coins.

Once they do, no one else will want to sell and the price will start to recover. While this bounce is in progress, start planning to be better prepared for the next market crash.

In other words, when you fail, don't lose the lesson.

Results

Market correction is a natural part of financial market cycles. These adjustments are necessary to bring the estimates in line with long-term averages and the upward trend.

When trading, you can notice signs of upcoming corrections in order to take measures to protect your portfolio. If you're not ready, don't panic. The bigger the crash, the more it is exacerbated by unprepared traders or those who base their decisions on the emotions of the moment. Wait for the bounce to think about how best to prepare for the next time.