Tips for Navigating a Stock Market Correction

Playing the stock market can lead to capital gains in various ways as each investor or trader must develop their own strategies. Swing traders emphasize technical analysis while long-term investors focus on financial fundamentals. Sometimes an Initial Public Offering (IPO) can pay off nicely in a short time. Another strategy is to play for gains from market reversals. Here’s what to know on navigating a stock market correction.

Develop a plan for your investments

Portfolio Diversity – It’s dangerous to devote all your capital to one stock. The safest way to invest is to diversify your investment portfolio. That means own certain equities that act as a hedge against other equities. Choosing a basket of stocks or ETFs that represent different market sectors can help balance the ups and downs of price action. Other ways to diversify a portfolio include investing in real estate investment trusts (REITs), fixed income funds and mutual funds.

Overtrade Rules – Don’t allow yourself to get so caught up in the emotion of trading that you trade excessively in a short time frame. Overtrading can lead to quick losses and vulnerable market positions. The amount of money in your trading account somewhat dictates how you can use your funds for trading. Successful swing traders often average down on price declines then profit on reversals. But at some point if you keep buying lower you may run out of capital. And if the price continues to sink, you’ll be trapped or have to consider selling for a loss.

Questions to ask for protecting investments

How does the stock market work? – Buying or selling a stock is simple with an online brokerage account. While each brokerage has its own platform design, the most competitive brokers give you easy but powerful trading tools. To purchase a stock you place a buy or sell trade either as a market or limit order. A market order executes at the current market price while a limit order only executes if the stock hits your chosen entry price.

When you trade based on anticipation of upward market moves, you take a “long” position. By contrast, you take a “short” position when you sell borrowed shares from your broker with the expectation the price will drop. Some of the most successful professional traders on Wall Street hold both long and short positions. To “cover” means to close out your short position, hopefully at a lower price.

The reason short selling exists is to give investors opportunities to capitalize on market declines. When excessive shorts pile on, it can trigger a short squeeze,” in which short sellers start to panic and cover their positions. Short selling is generally considered dangerous for beginning investors or traders. But it can be highly lucrative with proper risk management.

What is a stock market correction? – Stocks typically trade at much higher values than earnings per share. Sometimes stocks get overvalued by being overbought, causing market bubbles that are bound to pop or deflate. That’s why stocks go up and down in the battle between bulls and bears. Bulls are betting on a bright future while bears are betting on seeing through hype.

Market experts generally agree that a normal market correction can be a 10-20 percent pullback from a recent market peak. All stocks are subject to market corrections after they’ve risen or fallen significantly. Entire market indexes or certain sectors can also experience surges followed by corrections.

How do you prepare for a market correction? – Many times the solution to a correction is simply to do nothing and let the cycle play out. There’s usually no need to change an investment strategy during a modest correction. But when losses exceed your risk management threshold, you must consider lowering risk. Investors with large accounts can afford to sit through downturns better than those with small portfolios.

Some investors are able to benefit on market downturns by purchasing stocks at lower prices than their initial entry points. This strategy, known as “dollar-cost averaging” or “averaging down,” can amplify gains or losses. You must be ready to exit at a stop loss level based on your trading rules. It always helps to have cash on hand to buy on dips. Investors with large accounts can make exponential gains by buying hundreds of shares at low prices then cashing in on turnarounds.

Surviving Market Corrections

According to Forbes, there have been 27 market corrections since World War II. Most corrections only last a few weeks to a few months. When a decline continues for several months it’s considered a bear market, especially if the valuation has fallen over 20 percent. The key is to understand what’s causing the market correction, whether it’s big picture economics or simply a cooling off period after a hot run. Ultimately, your portfolio and trading style must match your risk tolerance.