Psychology of a Correction

One of the cornerstones of my approach to trading is the notion that corrections generally look pretty similar and that it is possible to sidestep the downside and thereby beat the market.

As I have mentioned numerous times, corrections typically have 4 stages:

1. Steep Drop #1
2. Recovery Rally
3. Steep Drop #2
4. High Volume Reversal

I believe that there is some pretty simple psychology behind this pattern that explains what it is seen so frequently.

Consider first what happens before the correction.  The market is usually in rally mode and moving higher.  Bears are slowly turned to bulls as the market marches inexorably higher.  Towards the end there are some sharp one-day sell-offs, but the market shrugs them off and continues to make new highs.  At this point, bullishness reaches a crescendo.

During the first steep drop and contrary to what you would read in the news – only the smart traders are selling.  The media will say that this is a panic, that the fundamentals are sound, and that only fools would sell into this kind of carnage.  The newly minted bulls that had recently convinced themselves that it was finally safe to make a long trade have now become “investors” – convinced that they will just ride this correction out.  Investors are more shocked than scared.

The recovery rally is really more of an absence of selling – which is why this phase typically features small gains and low volume.  The smart traders have already dumped their shares and the sell-off has become too extended, and so a mix of opportunistic trading and short-covering will drive the market temporarily higher.  The media will speculate aloud that the correction is done.

While the smart money sold during the first steep drop, the dumb money is selling during the second steep drop.  After the false bottom of the recovery rally, there is now genuine fear that this could be a bear market.  All of the traders-turned-investors that held on during the first drop are now capitulating and selling their shares.

The final phase, the high volume reversal, is key because it represents real buying and not the small gain / low volume buying that was seen during the recovery rally.  After the dumb money has capitulated and the last of the weak hands have been flushed out – the market will sharply rally back, trapping all of the newly minted bears in cash.  Those that just sold will be too stubborn to admit their mistake and buy back in – and they will wait on the sidelines for another leg down that does not come.  The foundation of a new rally has been formed.