Correction Vs. Reversal

Recently we have seen some sharp moves in relatively short periods of time in the commodity markets. Both in metals on the back of the US FED rate-cutting cycle along with Chinese stimulus, or oil after the escalation and involvement of Iran in the Israel/Palestine conflict. It is not sustainable for commodity prices to move up or down in a straight line indefinitely. While short- and long-term trends often establish themselves, any drastic price moves will only last a matter of days as market participants react to a particular catalyst. When inevitable sell-offs (in an up-trend) or buying (in a down-trend) occur, a lot of times the market will deem this ‘necessary’ in order to reduce the frothiness of any over-exuberance that has occurred. Some profit-taking will occur, allowing longer-term participants to re-establish or increase their positions in line with the prevailing trend. The real question we often have to ask ourselves is whether these moves against a recent pattern of trading are simply a necessary correction (also known as a retracement), that will allow the trend to continue, or if it is the start of a larger reversal as market participants change their strategies based on the current dynamics.

A correction will be temporary in nature, and will not lead to a change in the larger trend of that market. In an up-trend when the correction is over, the market will continue to make higher highs and when it drops, it will rally before breaching the previous low. One of the identifiers of an uptrend is a series of higher highs and higher lows. Conversely in a downtrend, a market will continue to make lower lows and lower highs.

A reversal occurs when the price trend of a commodity changes direction - an uptrend moves into a downtrend or vice versa. When this happens, the price will more often than not continue in the new direction for an extended period of time.

We have all been in these situations trying to make the best market timing decisions when a market starts to turn against our position - do we stop out and take profit (or at least mitigate further losses) only to kick ourselves when it was just a correction? Or do we stay in the trade and risk further pain if the correction turns into a full reversal?

It can be extremely difficult and frustrating when the market makes these moves. Unfortunately, identifying whether there has been a correction or a full reversal is an extremely tough job, and can only be proven in hindsight. Full reversals can also take time to materialize, from days to weeks or even months. Even the most skilled technical analysts cannot offer any guarantees - any who do are likely just trying to sell their ‘secret sauce’ to you and you should run far away! Proper money management and risk assessment (along with a decent amount of luck and experience) is the true way to survive these markets in the long run. There are however some repetitive traits to watch for that can increase your chances of being correct.

Moving Averages

Watching moving averages can play a key role in decision-making. A moving average is a simple technical tool that displays the running average of a commodity over a defined period of time. Some common moving averages are 10, 20, 50, 100, and 200 period averages. For longer-term trends, traders will typically focus on the daily chart. In this case, the moving averages would detail the average of the prior 10, 20, 50, etc. days closing prices. If in an uptrend the price moves lower through a moving average, it can be a sign of a larger reversal vs. a correction.

Trend Lines

Trend lines are often an important tool traders use to determine entries and exits from a market. They can be used to identify key levels of support and resistance in a market. Trend lines are drawn by connecting at least three higher lows in an uptrend or three lower highs in a downtrend. If the market price breaks through a well-established trend line, this can be a sign that a larger breakdown in the trend is occurring and the market is reversing instead of correcting.

Volume

Typically in a correction or retracement, the volume behind the move will be relatively low. The large, longer-term position holders are not rushing for the door and liquidating their positions. Profit taking by smaller traders should not lead to larger than average volumes on a given day. However, in a reversal, we see liquidation by large CTAs, funds, and traders who want to stem their losses and potentially establish new positions in line with the newly emerging trend.

Open Interest

In a correction there will likely not be a big shift in open interest, in an uptrend the market will remain net long and net short in a downtrend. When a reversal occurs, there will often be a shift in market positioning from overall net long to net short or vice versa.

In general, a correction will occur over a much shorter time period than a reversal. A correction will typically last anywhere from a few days to a couple of weeks, whereas a reversal is a longer-term change with no defined end. 

Corrections are typical after a knee-jerk reaction to a news event, where there is a potential shock to the market but the overall supply/demand fundamentals remain intact. For example, a market that is in a longer-term up-trend could rally hard on the back of a rumor of decreased supply, then sell off on profit-taking or the rumor disappearing - this very phenomenon gives us the phrase “buy the rumor, sell the news”. But given no fundamental shift in mindset, the uptrend is able to continue. Reversals more often occur when there is a change in underlying fundamentals or a large shift in mindset from the speculative community.

There are also various chart patterns and specific candlesticks in charting that some traders believe can be very good indicators of reversals. However, the debate is still very much ongoing as to how reliable these chart patterns are. For every technical analyst ready to explain double tops and bearish engulfing candles, there will be a fundamental trader telling you charting is the same as reading tea leaves. My advice - absorb as much information as you can from as many reliable sources as possible, (technical analysts, fundamental traders, macro traders, physical traders, funds, etc.), utilize stops to your best advantage, and have exceptional money management skills.