Traits of a Market in Correction

04/23/2014 6:00 am EST

Focus: STRATEGIES

Austin Passamonte of Coiled Markets details the characteristics of markets in corrective mode in hopes of preparing traders to adjust their strategies according to market conditions.

For the past several years, US stock markets chugged their way higher via QE-induced fashion; albeit on dwindling volume and waning volatility. Inevitably, that "trend" cannot last forever. The recent announcements of QE tapering coupled with other global factors have those same markets coming unraveled in the past couple of weeks here in April, what is usually a most bullish calendar month for stocks.

Considering the fact that equity markets rose mostly straight up with scant few (and very brief) pullbacks thru that time, a lot of today's active traders have never experienced corrective markets before. And maybe some of us who have traded through such have likewise since forgotten just how periods of higher volatility tend to behave.

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Rarest of All
Corrective markets always bring higher volume, rising volatility, and of course, expanded price ranges along with that. What had been an entire week's, if not calendar month's, average range in dull times before can now be covered inside one single pit session of trading.

The selloffs can be straight, sudden, and extreme. Which is why many traders evolve into short-side only bias.when markets are selling off, the gratification = reward of winning trades usually happens real soon after entry. Very impressive from a $ per contract perspective, too. But straight-trend sessions are always the rarest of all. They usually happen from out of the proverbial blue, when no one is really expecting that. Reason being? Straight-trend sessions unfold when all action is to one side as few traders (who actually move the markets) take the other side out of fear, confusion, surprise, or some combination of all three.

After a straight-trend day completes and the next session ensues, traders have recovered from the shock, adjusted to positions stopped out they never thought would be hit, and begin to establish orders long and short. That's fundamentally why most (not all) straight-trend sessions are followed by a next session of inside-range to "recover" from the extreme price move.

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Two-Way Street
Most sessions inside corrective market periods have plenty of two-way movement. Price will react around its open-range of the pit sessions as usual, head off in one direction, reach some technical levels of importance to the given market, and then reverse course to head the opposite way.

NEXT PAGE: Bullish Moves in a Bear Market?

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This is what we'll see most inside any given calendar month: sideways ranges, albeit expanded price distances covered across the charts. Higher volatility periods are precisely why intraday traders exist.heightened opportunity for profit potential between the session bells. Now is the time to enjoy much greater profit exits than times past in low-volatility periods where ranges were contracted to nil.

I would say the most important aspect is to expect trend moves but trust none of them to continue forever. Keep a close eye on those key technical levels. When key levels get hit, price action tends to react accordingly.

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Most Bullish?
One anomaly we'll often see repeated inside corrective periods of market action are extremely bullish price moves. These short-squeeze sudden spikes to hours-long directional swings seem to erupt from nowhere without any warning. But the common factor in most cases is early session selling, often high volume and extreme, which brings price levels down to their own daily road-map support zones. From there further selling is exhausted, sellers begin taking profits, dip buyers begin probing the long side and stop orders through levels above get taken out with gusto.

By far the most explosive, directional, and sometimes violent price moves upward happen inside of extreme selling pressure. Trading the trend is always most lucrative in any market stretch, and that is especially true when markets are selling off. However, it is important to keep in mind at all times that very few sessions (on average) in any given calendar month will be straight trends either way.

By all means short your sell signals confirmed, but resist with all your might the temptation to keep shorting into rising price action following sharp drops. If you fail to heed that disciplined approach, it's only a matter of time before you find yourself selling into a straight short squeeze, being part of the actual fuel taking it higher. Please don't do that, for your own sake.

Summation
No one on earth knows for sure what any markets will do with certainty, next. The best any of us can do is to prepare for various scenarios with an open mind and unbiased view. Then react accordingly when we see price action unfolding around the key levels we prepared for. Most importantly of all, we must believe what we see and act accordingly. If that means continued shorts into markets selling off, idle and flat during stretches of uncertainty or longs into price action rising out of extreme selling, trust the discipline that you see.

By Austin Passamonte of Coiled Markets

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