Do Not Be Confused Between A Correction, Pullback, and a Reversal

Investors and news portals in Nepal use these words interchangeably. While it may not have much implication on the surface level, these three terms are inherently different. They all vary in the length of formation, percentage fluctuation, and the implication of the psychological trend.

Correction

A correction is a decline of 10% or more in the price of a security from its most recent peak. Corrections are short-lived and typically last no more than four months.

Corrections may not be alarming to long-term investors. However, a technical trader investing for shorter timeframes should look out for corrections since it is not fun to have one’s money invested during a correction. It is a waste of time, even if you come out from a correction fairly even.

No one can pinpoint when a correction will start, end, or tell how drastic of a drop prices will take until after it’s over. What analysts and investors can do is look at the data of past corrections and plan accordingly.

While writing this, the NEPSE index is going through a correction with a 10%+ decline.

A correction in a bull market is a positive signal for some trend followers. Corrections do the job of calming overinflated markets and give an opportunity for the left ones to enter the market. However, if you are already invested in stocks, you should follow your stop loss strategies religiously to avoid being caught in the entire course of the correction.

Furthermore, we are never sure that the downtrend is a correction until the decline stops and resumes the previous trend. In some cases, a correction may end up being a longer-term downtrend, called a bearish reversal.

Pullback

A pullback occurs when a stock “pulls” back to a resistance and/or support line. This usually happens after a breakout. A pullback is very similar to retracement​ or consolidation, and the terms are sometimes used interchangeably.

This illustration will make things clear:

Pullbacks can be in an uptrend or downtrend and can pull back upwards or downwards. If the security falls for a few trading sessions on a bull trend, it can be called a pullback. A pullback is most likely caused by investors taking profits on a bullish upswing. As such, it is profitable to enter after a pullback at a cheaper price since the primary trend is bullish. Pullbacks are only temporary.

Reversal

Unlike corrections and pullbacks, a reversal occurs because of a major change in company fundamentals or the overall decline of the stock market. A reversal is an incident, not a time period. In literal terms, it only means that the price or index reverses its major trend and goes in the opposite direction.

However, since the price or the index tends to continue with this reversed trend for a long time, we say that the reversal itself lasts for the long term.

The reversal in the NEPSE index that kickstarted the 4-years long bearish trend.

Technical analysts can look at further price movements and indicators to differentiate a reversal from a minor pullback or a correction. Meanwhile, fundamental analysts can study whether the fall in the price or index is caused by a change in major company fundamental or macroeconomic data or whether it is only caused by profit-taking and a response to calm inflated markets.

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