A market crash or a market correction can leave a wake of devastation…
When the stock market — or even just a single security you’re holding — takes a nosedive, it can be horrifying. Watching your holdings and account suddenly wither is like a cold stab of fear to the heart.
But does that mean you need to immediately cut your losses and sell all of your positions? Not necessarily. Before you hit the panic button, take the time to educate yourself on the difference between a market crash and a market correction.
Both of these market phenomena involve dropping stock prices, but there are some important differences. By gaining an understanding of the key differences, you can better position yourself to make trading decisions with the big picture in mind.
In this post, you’ll learn the difference between a market crash and a market correction, as well as tips for how to take advantage of both.
Table of Contents
- 1 What’s a Market Crash?
- 2 What’s a Market Correction?
- 3 What’s the Difference Between a Crash and a Correction?
- 4 How to Prepare for a Market Crash or Correction
- 5 Conclusion
What’s a Market Crash?
Along the San Andreas fault, everyone dreads ‘the big one’ — the earthquake to end them all.
A market crash doesn’t mess around. Typically, it happens in a short time period … It can happen in as little as a single day and usually not more than a few days. Of course, more declines can continue for a while after (but usually more gradually).
Probably the most famous example of a stock market crash is 1929’s Black Tuesday (and its lead-up, Black Monday) when the Dow Jones Industrial Average plummeted 25% over two days and led to a huge sell-off from panicked investors.
After this initial shock, the market went into a slow but steady decline, plummeting 48% within two months and kickstarting the Great Depression.
But not all crashes last as long as the Great Depression. For instance, another massive crash happened in 1987, when the Dow plummeted nearly 23% in a single day. This was the worst single-day drop in history, but the market was already on the road to recovery as soon as a year later.
Important and worth noting: Whenever the Dow plunges, people are quick to use the term ‘crash.’ But from a big-picture perspective, market crashes are pretty rare.
What Causes a Market Crash?
Usually, something happens to trigger a market crash. It could be any number of catalysts that fall into “the straw that broke the camel’s back” territory. Typically, a crash is a result of bigger economic factors, such as…
- A slowing economy. This is probably the biggest reason why the market will decline. The market goes in cycles. Or put simply, what goes up must come down. If the market is on a steady uptrend, it’s bound to go down at some point. If the economy is going into a state of recession, or even if big investors are expecting the economy to slow down, investments tend to slow down, too.
- A lack of optimism. Have you ever heard the terms bull market and bear market? These terms refer to an uptrending and downtrending market, respectively. During a bull market, people are excited, optimistic, and ready to buy. But during a bear market, there’s a lack of optimism that can make people major tightwads. When nobody’s spending money, the general attitude is that nobody’s making money. That can lead to a market downturn.
- Fear as a self-fulfilling prophecy. Buyer sentiment can have a huge effect on the market. When the news or big investors are throwing around the phrase ‘market crash,’ it can strike fear in the hearts of traders.This fear can inspire people to sell off positions in a panic, and it can keep them from buying stock. When nobody’s buying, sellers have to lower their prices … and drops in the market can become a self-fulfilling prophecy.
- Major world events. World events can shake the market in huge ways. Just look at how the current U.S.-China trade war has been making stock prices move in recent months…That’s just one example of a major world event that could affect stock prices, though. Natural disasters, terrorist attacks, oil shortages, or wars would also fall into this category.
More often than not, a market crash is caused by a variety of these factors rather than just one.
What’s a Market Correction?
A market correction is generally viewed as a drop of 10% or more in the stock market, an index, or with the price of a specific security. Usually, this drop is from recent highs.
To illustrate an example of a correction, let’s say that Stock X is flying high because the sector is hot and a related company just had a positive news catalyst.
Stock X’s price might be inflated based on hype and sympathy plays. But since there might not be any firm reason for Stock X’s price to be higher, the price will eventually fall or ‘correct’ itself.
However, a correction could have a much greater reach than a single security. A correction could occur within a sector or even across the entire market.
This is worth noting: Market corrections are fairly common and happen with much greater frequency than market crashes.
What Causes a Market Correction?
Really, the term ‘correction’ kinda tells you all that you need to know (but don’t worry, I’ll spell it out).
The fact that it’s a correction implies that something hasn’t been quite right. In the broadest sense, it’s stock prices — across the board, within a sector or for a single security.
A correction occurs when the price is edging too high for no good reason. Eventually, the price will inevitably fall. Sometimes, the drop can be pretty dramatic, but unless there are bigger economic problems at hand, a correction generally levels out at a more appropriate level.
So while market corrections are the enemy of the short-term trader, they’re pretty normal for long-term investors.
What’s the Difference Between a Crash and a Correction?
So now that you know what a market crash is and what a market correction is … what’s the difference, exactly? Let’s talk about specific differences.
Scale of the Price Drop
The scale of a market crash is usually much bigger than a correction. In general, when you talk about a market crash, you’re talking about the entire market rather than a single security.
With a market correction, on the other hand, the scale could be large, but it could also be pretty small. A market correction can occur within the market at large, but it could also occur with a specific sector or stock.
Amount of the Price Drop
The downward trajectory of prices differ between a market crash and a market correction.
A market crash makes a big splash. Price drops are sudden and dramatic and hit stocks across the board — sometimes 20% or more — within a very short time period.
A market correction, on the other hand, is a 10% percent or greater price reduction, but that’s often from recent highs that could be unsustainable.
Speed of the Price Drop
One thing that can make a market crash so scary, other than the percentage drops, is how quickly it happens. It’s not unusual for a market crash to occur over a single day or series of days.
Corrections can sometimes happen quickly but may have a slower process. So you might see a single-day market correction, or it could happen over a longer period.
The catalysts for a crash versus a correction can be different, too.
A market crash is generally more complex than a market correction. It typically happens after a period of uptrend in the market. It may be the result of an economic downturn following highs, a lack of investor optimism, world events, or a combination of factors.
A market correction typically occurs when a stock — or the market at large — has become inflated without a solid reason. The correction, in essence, brings the inflated prices back to normal.
The aftermath of a crash can look different compared to a correction, too.
A crash can be short term, but it could also be the beginning of a longer-term market downturn, as in the case of the Great Depression.
But a correction is typically a ‘one and done’ kind of deal. The price goes up, then it’s corrected and levels out. And life goes on until the next correction.
How to Prepare for a Market Crash or Correction
There are certain signs that a crash or correction might happen. Examples include a sustained period of high stock prices or major world events that could shake the markets.
But it’s impossible to know exactly when or how either a market crash or correction will hit. There are simply too many factors at play. However, now that you understand a little bit more about these market phenomena, you’ll be better able to identify them when they occur.
Ultimately, education is the best way to prepare for a market crash or correction. When you have a knowledge base of what causes a crash or correction, you can learn to view the situation more calmly. When you take the panic out of the equation, you can make more intelligent trading decisions.
One thing I like to teach my students is that no matter the market condition, there are always opportunities for savvy traders. You want to learn to observe the market as it is and base your trades on that. Trying to force trades based on what you want to happen … that’s not a strategy or realistic.
FOR EXAMPLE, in the case of a market correction, there could be chances to buy into the price dips and benefit from longer positions. Or, if you believe a correction is on the horizon, it could be a good time for short selling.
Even a market crash can provide potential opportunities. Traders can look into short selling or look at securities or commodities that might thrive in difficult market conditions. Certain sectors seem to be more resilient and can continue to perform strongly.
Really, it’s a matter of doing your research and finding the best opportunities. With a strong foundation of trading knowledge and a great stock screener like StocksToTrade, you can hone a sharper eye to help find these opportunities.
So how can you begin to forge a strong foundation of trading knowledge to help you better weather market storms?
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While some traders will use the terms crash and correction interchangeably, there is, in fact, a difference. A crash is an event that shakes the market at large, where a correction can be on a much smaller scale.
Take the time to educate yourself on events like this. These market events can move the indexes and stock prices, so you need to know how to adjust your trading approach and strategies.
You want to make intelligent decisions when it comes to trading, right? Knowledge is power in the markets, and it can help you make educated and smart decisions regardless of the current market conditions.
How have market crashes and corrections affected your trading? Leave a comment and let me know your thoughts!