Type in the words, “stock market correction” into any search engine and it is almost a guarantee that you will be inundated with articles that preach an impending deviation from the current bull market rally that has run largely unabated since 2010. Along with the words “inflation”, “deflation,” and “recession”, “correction” serves to invoke a sense of apprehension and dread within the public’s perception of a fragile and manipulated market, held up by the threads of capitalistic greed and corruption. One of the tools that can help a trader avoid or even take advantage of a correction is the trend line.
This article will briefly define what a correction is, how they fit in with trend lines, and how to use trend analysis and trend breaks to help determine whether a correction is on the horizon.
What is a Correction?
A correction is more or less a deviation from an uptrend in a stock. During a correction, prices can drop around 10% or so from their highs. A correction is not a crash, nor is it a precursor to a sustained bear market. However, corrections CAN lead to such events, but more on this later.
So What is a Trend?
A trend can come in two variations: an uptrend in price, which consists of higher highs and higher lows, and a downtrend in price, which consists of lower highs and lower lows. The simplest way to gauge the direction of a trend is to simply look at the chart and draw a trend line connecting the peaks and valleys. A general rule of thumb would be to connect the lows of the trend (usually two or more) for an up trending stock and the highs for a down trending stock. Below are charts of Apple Inc. (AAPL) and 3D Systems Corp. (DDD). As you can see, APPL has been in an uptrend since April of 2014, while DDD has experienced a sustained downtrend since January of 2014.
Another useful tool to help determine the direction of a stock’s price is the moving average. The most basic type of moving average is the simple moving average (SMA). The most basic way of using the SMA is to determine whether the stock has crossed its moving average from below and is trading above it (uptrend) or crossed the moving average from above and is now trading below it (downtrend). Notice how APPL crossed its 100-day moving average in April of 2014 and has been trading above it ever since, while DDD crossed to below its 100-day moving average in February of 2014 and has been encountering it as resistance ever since.
Ok, so AAPL is going up, and DDD has been smashed for over a year: what good does this information do for the investor? As the old adage goes, the trend is your friend, and based on this principle, a trader or investor would want to go long anytime a stock is in an uptrend and go short whenever a stock is in a downtrend. Each time AAPL pulls back to its trend line or moving average, a bullish investor should seek to go long, and conversely, each time DDD pops up to its trend line or moving average, it should be shorted.
Trend Lines and Corrections
Trend lines can be used over any number of time periods: from mere minutes for day traders to weeks, months, and even quarters for long-term buy-and-hold investors. The principle remains the same: higher highs and higher lows equal uptrends, and lower highs and lower lows mean downtrends. The real crux of trend analysis lies in the trend break. A trend break is just that: the price action breaks through the trend line from above during an uptrend and from below during a downtrend. Trend breaks have to be watched carefully, as they can be a precursor to further corrections or sometimes, but not always, a complete reversal of trend.
Furthermore, the area in which the trend is broken often serves as resistance, as traders who went long at the dip got caught in a sell-off and are now waiting for their chance to exit their trades at break-even when the stock climbs back to their entries. Thus, these once buyers are now sellers, and contribute to sell off pressure that may develop at the new resistance level. If the selling pressure at this level overwhelms the buying pressure, the once uptrend can be completely dissolved into a sustained sell-off.
Beginning in October of 2014, Skyworks Solutions Inc. (SWKS) made a run from $50 to a high of $102.77 in March of 2015, a gain of 105%, before correcting with high volume to a low of $88.25. The trend line was broken on March 25, and ever since then, the stop has been consolidating sideways between $92 and $99 although it attempted to resume the uptrend on March 30.
SolarCity Corporation (SCTY) also experienced a remarkable uptrend lasting from September 2013 to February 2014 in which the stock rose from $28 to $88 (214%) before the trend was broken during a frenzied sell off in March 2013. The trend was retested from the downside without success, and the stock saw a downtrend for the next three months with a low of $45—a complete trend reversal.
So how does one anticipate these corrections? Surely no trader wants to go long when SWKS, SCTY, or even the incredibly bullish AAPL corrects at the peak of their uptrends. One way to determine if a correction is imminent is to gauge whether the price has ran up incredibly quickly in a very short amount of time. Technical indicators such as the relative strength index (RSI) can help the investor assess whether something has been grossly overbought, while fundamental factors such as the P/E ratio can also assist in circumventing corrections.
However, trend lines themselves can also be incredibly useful in determining whether a correction is around the corner. As previously mentioned, trend lines can be used across a multitude of time frames, and to limit yourself to daily or weekly trends can make you miss the minute details that the broader movements are based upon. Let’s look at an example using the S&P 500 ETF (SPY). On the daily chart, the SPY is in an uptrend but it has experienced some corrections around the 212 level. Zooming into the hourly, we can see that in February of 2015, the SPY first attempted to close above 212, but was rejected and broke the trend line from above at 211.73. This level served as resistance, which the SPY could not break through and stay above, later sending the index towards the 204 area.
Ever since the trend break, the SPY has attempted to break through this level multiple times, each time meeting strong resistance and correcting as evident by the mini-trend breaks on the hourly chart, each time it reached this level. If the trader had only focused on the SPY’s weekly or daily trend, they would have missed these small details and might have erroneously gone long at key resistances/mini-trend breaks. Such bad entries can lead to unnecessary financial and emotional stress that could have been avoided if the hourly charts have been examined prior to entry.
The Bottom Line
Trend lines are incredibly useful tools in determining the direction of a stock and developing a bullish or bearish stance. Trend analysis includes the use of trend breaks, which may signal corrections or complete trend reversals. Trends can be drawn across multiple time frames, and the smaller trends may help an investor or trader avoid the corrections that occur over larger time frames.