What is a market correction?
Everyone has a slightly different opinion on what qualifies as a "market correction." However, most economists agree that corrections happen when the price of an asset falls by about 10% from its most recent high. Typically, corrections take place over a few days or weeks of trading.
While a market correction can potentially lead to a sustained bear market, it won't trigger a substantial fear-induced sell-off (aka capitulation). Indeed, many market corrections lead to a period of sideways price action. It's also possible for prices to recover shortly after a correction.
Most often, market corrections aren't related to external news events. Instead, these corrections are a normal function of supply and demand. When there aren't enough buyers in a given market, sell orders begin outpacing buy orders, which lowers prices.
Market corrections happen in all asset classes, including equities, bonds, and cryptocurrencies.
What is a crypto market correction?
A crypto market correction refers to a significant price decrease in crypto assets that lasts for a few days or weeks. Compared with corrections in established financial markets like equities, crypto corrections are usually more severe. Other than crypto's higher volatility, these corrections mimic all the traits of traditional corrections.
It's common for a cryptocurrency's price to go down below 10% during a correction phase. Generally, altcoins (or non-Bitcoin) experience steeper corrections versus Bitcoin (BTC), but BTC has had many steep declines throughout its history.
An example of a crypto correction in 2022 is change in price of Ethereum (ETH) before the Merge. In the weeks leading up to this highly anticipated upgrade, ETH rallied from about $1,400 in July to nearly $2,000 in August. However, as buyers started drying up, ETH's price decreased to around $1,400 before rallying slightly at the start of September.
What causes a crypto market correction?
It doesn't take catastrophic events to cause a crypto market correction. Indeed, most of the reasons behind corrections are due to low market demand.
- Low demand, high supply: The most common explanation for a market correction is that demand starts drying up. Prices can only continue rising as more people are willing to pay for an asset. When the cost becomes too high for most buyers, sell orders will outpace buy orders, which can trigger a correction.
- Swing or day traders start taking profits: Short-term traders may exert extra pressure on a cryptocurrency's price if they decide to sell a significant amount of their holdings.
- Abnormally high levels of crypto leverage liquidations: Crypto leverage refers to borrowing capital from an exchange to increase exposure to a digital asset. Since crypto prices are inherently volatile, there's a greater risk that leverage traders will lose all their borrowed funds (aka liquidation) if a token's price trades against their strategy. When there's a significant number of liquidations across major crypto exchanges, it can trigger a correction.
- Short-term speculative bubbles: Parabolic short-term rallies in the cryptocurrency market usually aren't sustainable. No matter how solid the fundamentals behind a crypto project are, there’ll come a time when sellers emerge. If a digital asset’s price rises too high and too fast, you should expect a correction as more traders begin taking profits.
- Crypto news: Major news stories are more commonly associated with market crashes than corrections. However, crypto-related events, articles, and rumors can always impact a token's price. There may be cases when these news stories trigger a market correction.
Is a correction different from a market crash?
Market crashes are more severe than corrections. While corrections can take a few days or weeks to play out, a crash usually occurs within a shorter time frame. In traditional markets like the stock market, asset prices usually fall within a 10-20% range. Since digital assets are more volatile, coins and tokens can fall well more than 20% during a crypto crash. The smaller and more speculative an altcoin is, the more likely it’ll drop more than 20% during these periods.
Market crashes tend to be driven by significant news events or macroeconomic data. For instance, the price of Bitcoin fell 40% in one day when the WHO declared COVID-19 a global pandemic. As another example, Bitcoin also crashed from roughly $32 to $0.01 in 2011 in response to news that hackers broke into the early BTC exchange Mt. Gox.
The sentiment during a market crash differs from that of a market correction. While crypto holders tend to feel incredibly fearful during a crash, corrections don't cause mass panic in financial markets.
Prices may recover after a market crash, but it's more likely these severe drawdowns will lead to a bear market. Officially, if the price of an index or asset falls by more than 20%, there's a high chance it’ll enter bear market territory.
Can people predict a crypto price correction?
Predicting a price correction is difficult, especially in the volatile cryptocurrency market. However, here are a few technical indicators traders use to gauge the likelihood of an upcoming correction:
- Trend lines: Technical trend lines show the average price of an asset over a pre-set timeframe. For instance, Bitcoin's 50-day moving average shows the average price of BTC over 50 days. Traders often use these trendlines to gauge when the market may be overheated. Generally, if a token's market price is far above multiple trend lines, it may signal the need for a correction.
- Resistance and support levels: Traders can also draw horizontal lines on their charts to see where a digital asset's prices tend to bounce. Resistance levels are high prices where a crypto struggles to break through, while support levels are lower prices where a coin tends to find buyers. As prices move closer to strong resistance levels, it may signal a correction is coming up.
- Relative strength index (RSI): Created in the 1970s, the RSI measures how quickly an asset's price moves each day and assigns a number between zero and 100. The closer the RSI is to 100, the more likely the asset is overbought. Typically, when the RSI is high, it signals the end of a recent rally.
- Trading volume: Usually represented by a bar graph, the volume shows how much of a cryptocurrency traded hands during a trading session on an exchange. If traders notice unusually high positive or negative trading volume, it may signal a correction is on the horizon.
What to do during a crypto correction?
Although there's no way to avoid crypto market corrections, you can consider the following strategies during correction periods:
- Consider dollar-cost averaging (DCA): DCA refers to a strategy of buying small amounts of an asset over the long term. Corrections may be a good time to use a DCA strategy to reduce your crypto investment’s average price. Often, you can set automatic DCA buy orders on centralized exchanges (CEXs) whenever a cryptocurrency drops by your preferred percentage.
- Remember your crypto investment strategy: Have a clear investment plan before buying your chosen tokens. This helps you stay focused on your long-term financial goals during extreme market volatility.
- Set stop losses for short-term trades: If you're considering a short-term crypto trade, a potential way to protect your position is to set a "stop loss" limit order. These automatic orders will sell your crypto at a predetermined price. While you’ll take a loss if this order activates, it can save you from further losses in the event of an unexpected correction.
- Consider staking cryptocurrencies: Some long-term crypto holders lock their crypto in a staking pool to resist the temptation to "panic sell" during corrections. Since the crypto in these pools is locked for a set timeframe, it's impossible to liquidate tokens quickly. This strategy may be good if you want to hold your crypto for years and struggle with emotion-based trading. As a bonus, you’ll get regular token rewards for staking crypto.
It doesn't matter what asset you track––there’ll always be price corrections over time. Buying pressure never lasts forever, and there’ll be times when sellers and shorts drag prices down. Whether you choose crypto, equities, or ETFs (exchange-traded funds), always plan for plenty of corrections along the way.
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