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Market Correction: CNBC Explains

Trader on the floor of the New York Stock Exchange.
Getty Images
Trader on the floor of the New York Stock Exchange.

A correction may sound like it means something is getting 'fixed' on Wall Street, but actually it's a word used to describe both a trigger for financial losses, as well as buying opportunites for investors.

So what is a correction? How does one come about? What does it mean for the stock market? CNBC explains.

What is a correction?

A correction is a decline or downward movement of a stock, or a bond, or a commodity or market index.

The amount of the decline is at least 10 percent and a true correction exceeds that amount.

In short, corrections are price declines that stop an upward trend.

Why do corrections happen?

Stocks, bonds, commodities, and everything else traded on the markets never move in a straight line, either up or down. At some point their value will change—for better or worse.

When stock or bond prices go up, it may seem like there's no end to how high they can go. When this happens, stocks or bonds become 'overbought.' That means some investors will try to buy into the rise of stock prices with the hope of making profits before a downward trend begins.

But as they do buy in, the investors who bought earlier—helping to push the stock or bond price up—will consider selling when they think the price is near a peak. Investors might base their thinking on an earnings report for a certain stock that shows flat profits, or a belief that a certain industry will face trouble. Any kind of 'bad' news can trigger a sell-off.

And sometimes, investors will simply take profits as the market heats up. In either case, the selling pressure drives prices down.

How long do corrections last?

Corrections generally last two months or less. They usually end when the price of a stock or a bond 'bottoms out'—for example, some will point to a stock reaching a 52-week low—and investors start buying again.

How is a correction different from a bear market or "capitulation"?

A correction is shorter in length and generally less damaging to investors than a bear market. A bear market happens when equity prices keep falling and investors keep selling into a downturn of 20 percent or more for the overall market.

The difference between a capitulation and correction is simply that a capitulation is more severe. A capitulation, is said to occur when investors try to get out of the stock market as quickly as possible. It's also described as panic selling. Capitulation usually is based on investor fears that stock prices will plunge even further than the current low levels.

Bottoms—or the lowest price for a stock or market index—are formed more quickly in corrections than in capitulations.

Is a correction good for the market?

Many investors and analysts look at corrections as a necessary 'evil' to cool off an overheated stock or bond market. This is to prevent a huge sell-off or 'bubble burst,' as what happened with Internet stocks in 2000-2001.

It's believed that corrections adjust stock prices to their actual value or "support levels," and so, are not overpriced or inflated.

Many short-term investors look at corrections as a buying opportunity when the stock or the overall market has reached a bottom or the lowest price level. Their buying helps push the price back up and stops the correction.

What is an example of a correction?

Corrections are fairly common. We can look at the S&P Index to see one.

As the chart below shows, the S&P 500 closed at 1,363.61 on April 29, 2011, its highest level since June 5, 2008.

On Thursday, Aug. 4, 2011, at 11:26 a.m. ET, the S&P 500 hit a low of 1,225.95, entering “correction” mode, defined by a drop of 10 percent or more.

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