Tips on Technicals - Corrections in Perspective
Most practitioners of technical analysis will agree that no market moves in one direction forever. After a rally or decline, the market will pause as winners take profits, losers cut their losses and the second round of positioning takes place. Terms like correction, consolidation and retracement are fairly interchangeable although some would argue that the shape of the pattern created distinguishes them. In most applications, a correction takes place after a significant change in accepted market value. The correction's shape and size are intimately related to the move being corrected.
The Right Way
Without going into precise measuring techniques and strict interpretations, a correction is a move in the opposite direction of the trend. Figure 1 shows how a normal correction fits into the ebb and flow of the September 1997 CSCE Coffee futures contract. In March, the market set an intermediate-term peak and broke a steep rising trend line to the downside (not shown). This turned into a declining flag pattern typical in most markets. The bottom of the flag occurred at approximately the 50% retracement level of the December 1996 - March 1997 rally1. Both the subjectivity of the flag and imprecision of the 50% retracement low are entirely normal in their deviations from "text book" patterns.
After the top of the flag was broken to the upside, the rally continued. Hindsight shows that the length of the rally from the December low to the March peak and the March low to the May peak were related. This relationship was based on Fibonacci number where the second leg of the rally was 1.618 times the length of the first.
The point of all this is that a normal correction, whether it takes on a flag, triangle or rectangle shape, occurs after a reasonable move. It retraces a reasonable portion of that move and then the market continues on for another reasonable rally. We do not have to define "reasonable" here as we are not interested in quantitative proof. Visual measurement and classification of the chart will be good enough.
The Wrong Way
Problems arise when the technician gets impatient or tries to force meaning on a chart that the market has not put there. In figure 2, the August COMEX Gold contract was in a steady downtrend until it dropped sharply in early July 1997. The price action that followed appeared to be a rising flag which would be an expected pattern at that point. On July 15, the market broke below the flag in what looked like a continuation of the bear market. The problem with this analysis was that a 6-day flag pattern that retraced about $9 was not sufficient to correct a decline that was 3 months old and $40 long (based on the intermediate peak in May).
Figure 3 shows the same chart a few weeks later. The flag pattern is still a valid interpretation but it grew to cover nearly 1 month and $15. The top of the flag reached a Fibonacci 38.2% recovery. Additionally, it was close to the declining trend line that defined the market before the July plunge. Now we have a reasonable move, reasonable correction and the possibility of another reasonable move to the downside.
Keep in mind that the next leg down may not materialize. The point is that selling the apparent break July 15 was premature. While there are no guarantees, the break August 5 was a much higher confidence trade.
1 See chapter "Fibonacci Retracements"
