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What is a market correction in trading cryptocurrency, and how should traders respond to it?
Corrections make regular appearances in financial markets, especially for crypto. Every crash started as a correction, but not all corrections lead to crashes.
In this article, we’ll discuss what a market correction is, what happens during a correction, and what you should do to prepare for it.
Understanding Market Cycles
Market cycles comprise bull rallies and bear corrections in all of the financial markets. In general, markets never move in straight lines as there’s an ebb and flow, a back-and-forth of pricing that shakes out weaker holders.
Market cycles have been around since the beginning of trading, and this phenomenon continues with Bitcoin and other cryptocurrencies to this day.
A market correction is a decline of ≥ 10% in the price of an asset or financial market. Corrections can span any amount of time lasting from a matter of hours to months — or even years.
The decline is called a “correction” because the dip is fairly small, and usually indicates that the cryptocurrency had rallied too far from its established trend. In the crypto market, corrections are more frequent than with stocks and can happen within a matter of hours due to crypto’s volatile nature.
Corrections are usually followed by recoveries, but they can lead to more pronounced declines known as bear markets.
Market Correction vs. Bear Market: Differences
Bear markets are larger market corrections, with declines of 20% or more.
A bear market is believed to receive its name from the way a bear attacks its prey by swiping its paws downward. As a result, bear markets are synonymous with downward and falling prices.
The biggest difference between a market correction and a bear market is the depth of the decline. A fairly shallow market correction will have a decline of 10% or more. However, if the decline digs deeper, to greater than 20%, then it’s no longer called a correction but a bear market.
What Happens During a Market Correction
The most obvious result of a market correction is an adjustment of prices to lower levels. For a variety of reasons, traders and investors feel the current pricing is too high and not worth the risk of tying up their capital.
As a result, current investors decide to sell all, or a portion, of their holdings to lock in profits. New investors who are considering buying put off their investments with the hope of buying them in the future at lower prices.
Declining crypto prices begin to draw in and attract more buyers. These investors are interested, having previously felt that the pricing was too high. Now that prices have declined, they’re motivated to make their investment, and the price rebounds in a rally.
What Triggers the Correction
The list of reasons a market correction begins is potentially quite long and debatable. Not every analyst would agree on why the correction is unfolding, and the reasons aren’t always obvious.
A lot of times, the introduction of new, negative catalysts can trigger investors to sell. For example, rumours of a potential war erupting — or a pandemic being declared— can spook investors, causing them to sell.
What Should You Do During the Correction Period?
At their most basic level, market corrections occur because investors and traders are more motivated to sell than to buy. Every decline starts as a correction. However, we don’t know (until after the fact) if the correction is turning into something deeper, like a bear market or a crash.
Therefore, it’s important to manage trades before a correction appears, and after the correction has begun. Here are three strategies to help give you perspective and a plan through a correction.
Trading Strategy 1: Removing Exposure
This first strategy is based on preparing for a correction. If you see clues for a developing top in the crypto markets, such as bearish candlestick formations or oscillators turning down, then consider reducing your long exposure.
The quickest and easiest way is to sell out of all your positions.
Trading Strategy 2: Buy the Dip
Whereas the first strategy prepares for a correction, this second technique is geared toward the action to take after the correction has begun.
As the crypto market begins to correct lower, technical levels of support will begin to break. Generally speaking, longer-term support levels tend to hold up better than shorter-term levels. Therefore, when the market corrects, identify these longer-term support levels on your chart and use them as opportunities to buy into the correction.
Trading Strategy 3: Dollar-Cost Averaging
A third strategy is dollar-cost averaging, intended for those traders who are newer chart readers. This strategy will help them remain invested for the long haul — while not getting whipsawed out of good positions.
When you’re HODLing a cryptocurrency, volatility can erupt without notice and erase the floating gains you’re carrying. Dollar-cost averaging (DCA) is a solution to this volatility.
DCA is a way to divide up your total investment, as it initiates regular systematic entries. With DCA, you can lessen the effect of price volatility because sometimes you’ll be buying at higher prices, and other times at lower prices.
What If the Market Continues to Crash?
Crashes in the crypto market are common and normal. If the market is collapsing, the best thing you can do is stay calm. If you’ve had a trading plan since before the crash, then execute that plan. For example, if the plan calls for DCA and buying more at a lower price, then go ahead and move forward with the plan.
If you don’t have a plan and feel yourself becoming more emotional as prices are crashing — well, remember that all crypto crashes have rebounded. That doesn’t mean that prices will always rebound. Nevertheless, one prominent effect of a crash is to drive weaker hands to sell their coins.
Once they’ve done so, no more traders want to sell — and the price begins to rebound. As this rebound is taking place, begin to make a plan so you’re better prepared for the next time the market crashes.
In other words, when you lose, don’t lose the lesson.
Finally
Market corrections are a natural part of financial market cycles. These corrections are needed to bring valuations back in line with longer-term averages and trend growth.
When trading, it’s possible to spot clues to upcoming corrections so you can take action to protect your portfolio. If you find yourself unprepared, don’t panic. The stronger the crash, the more it’s exacerbated by unprepared traders or those basing their decisions on the emotions of the moment. Wait for the rebound to consider how you’ll prepare better for the next time.
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