Corrections are price declines that are temporary, and interrupt the uptrend of an asset in the market. A correction can work as a precursor to a recession or a bear market, but it is shorter in duration than them. Experts analyze whether a market is heading for a correction by comparing one market index to an index that is similar in nature.

Understanding Correction

A correction might be in place if a market shows a trend of closing lower. Though, correction in the market can’t necessarily tell us how a stock in performing. Stocks sometimes tend to remain strong, and do well despite corrections or they can remain the same or go even further down than the overall market. Corrections are a great way for investors to find out about good companies, and to buy their stocks at bargain prices.

How Does It Work?

The stock market is always changing and it can even experience short term gains, even though things won’t really change. If the value increases it is usually due to psychology of the masses, according to which investors are driven by anticipation of perceived gains, where they buy the stocks so much that its price increases. Once the price is really high, the investors sell their stocks in order to maximize their profits. The decrease in price after an increase is known as market correction.

Take the example of a stock that costs $10. Due to multiple buyers the cost might increase $50 in two weeks. At the end of the second week, investors will stop buying due to the high price, whereas others will start selling their stocks in order to get more profit. The market will readjust, and the price will adjust to $40. So the changes are the correction that the stock experiences.

Why It Is Important?

Corrections in a stock’s price indicate the stock’s market value. Financial experts use technical analysis in order to determine when a correction start and end, because by doing this they buy stocks when the prices are low.

Further Reading

  • Dynamic linkages between the New York and Tokyo stock markets: a vector error correction analysis – [PDF]
  • Correction to “Automatic block-length selection for the dependent bootstrap” by D. Politis and H. White – [PDF]
  • Correction: Exchange option under jump-diffusion dynamics – [PDF]
  • Cointegration, error correction representation and the import demand function with implications in international finance and accounting research – [PDF]
  • A vector error correction model of the Singapore stock market – [PDF]
  • On the slope-aspect correction of multispectral scanner data – [PDF]
  • Co‐movement of Bangladesh stock market with other markets: Cointegration and error correction approach – [PDF]