A market correction refers to a price decline of at least 10% of any security or market index following a temporary upswing in market prices.
How It Works/Example:
The stock market's value is always rising and falling. Sometimes, the market will experience short-term gains, even though nothing has really changed. These increases in value are usually due to mass psychology on the part of investors driven by anticipation of perceived gains. As more investors buy into the trend, the price increases. Once the price is high enough, buying slows, and some investors begin to sell to lock in their gains. This decrease in price, following a short-term increase, is called a market correction.
To illustrate, suppose there is a stock XYZ that is currently valued at $80. Anticipating gains, investors continue to purchase XYZ, and the price of the stock goes up to $100 over the next month. At the end of this month, some investors stop buying the stock at the higher price, while others start selling the stock to lock in their gains. Consequently, the market readjusts and the price of XYZ stock falls to $90 per share. XYZ stock, therefore, experiences a correction of roughly 10%.
Why It Matters:
Market corrections are usually tracked once an upswing in market prices has come and gone. A correction in a stock's price following an upswing is indicative of a stock's true market value and may not indicate a loss in value so much as a market's return to stability.
Market corrections are a big part of technical analysis. Many investors will use indicators to try to determine when the correction will begin and end so that they can buy when prices are lower.