Market corrections are extremely emotional affairs, which is why they often yield an eminently tradeable pattern. (This is nothing new, and you’ll come across an A-B-C correction pattern in various guises under many different technical analysis philosophies.) Contrary to many other technical patterns it holds a distinct edge, but, due to the wild emotions in volatile markets and the many possibilities of the pattern to play out or fail, it is by no means simple to monetize successfully.

To counter the mood swings (During the initial market free fall: “The world is going to end!”; By the second day of any strong bounce higher: “We are running straight to new all-time highs!”), I have translated the pattern into a systematic, unemotional trade setup (link to the current setup in this week’s subscription report) that tries to combine a high probability of a positive outcome with a favorable reward : risk ratio.

The trade idea is very simple (as many of the best ones are): More often than not, a sharp correction during a strong bull market spooks complacent, over-leveraged traders and investors, and many jump at the opportunity to sell when equities start to bounce. Consequently, at least a partial re-test of the previous low happens about 70% to 80% of the time.

There is an edge in going short during the first bounce after a significant pullback in a strong rally.

While this article contains all necessary information to emulate my approach, you can also find exact entry and exit levels in my weekly subscription report — Check out all subscription options here.

Today, I want to dig into the details and go through different scenarios we might encounter during the next couple of days. On February 3rd 2022, we are currently at the suspected apex of the (B) bounce that retraces roughly 50% to 62% (Let’s go Fibonacci!) of the first (A) leg down, which was a considerable 12,4% market drop for the S&P 500 on an intraday basis. Because I often buy the dip during a bull market pullback, I use these levels to take profits on my long positions and build up short positions within that range.

Our monkey brain (and the news, as well as a majority of financial social media) will usually urge us not to do this, anticipating a linear rally to new highs. But, in fact, my backtests over the last 20 years show that this only happens about 20% of the time without any kind of second leg down.

V-Bottom

Straight to new highs with only minor gyrations on the way, which happened more often than usual in 2021 for example, is our low-probability fail case, which we must protect against with a stop loss. I place that stop somewhat discretionarily at an area of resistance near the previous high (at or above the 78% retracement of the initial down-leg).

A-B-C Correction: The second leg down

Eight out of ten times, however, we see a proper second (C) drop that can be quite profitable, and also a great opportunity to build long positions in a bull market. The catch is (yes, there always is one!) that there are quite a few different ways this can play out. I have grouped them into three distinct scenarios that all occurred about equally often in the last decades.

I — Not a leg to stand on
This is the most unsatisfying outcome, as the move down initially shows promise, but then simply starves after a day or two and reverses back up. Taking profits here would lead to a poor reward : risk ratio. But, at least in a correction as deep as the current one, we can use it to move our stop loss to break-even. 

No more money at risk!

II — Low Retest
A flat A-B-C pattern was actually the most common outcome during the backtest period, and it roughly retests the previous low. Because of the market’s inherent meanness (of course, it knows what most traders are up to), it often falls just a wee bit short of the actual low or overshoots intraday to run those stops placed just below. Therefore, I place the first exit for about half of my short position just a few points above the previous low.

For adventurous souls this is also a great place to start building a longer-term long position — but beware, it can go a lot deeper from here! With a remaining half of the short position on the books this risk can be somewhat mitigated, because the long position will be hedged until the second short exit.

III — Lower Low
This is the classic C-wave that we all know and love, but it is dangerous! In rare, but absolutely realistic, instances it can be the metaphorical falling knife that cuts anyone trying to catch it (just look at the pattern in March 2020: 30% straight down). For a short position this carries the prospect of spectacularly quick gains (these downside liquidations are fast). However, most of the time we will end up at a similar magnitude as the initial (A) leg down, which is where I put the trade setup’s short exit #2. 

Depending on the circumstances, it may make sense to split the remaining position into two partial exits, saving the second part for a windfall gain (and as protection for those long positions we may plan to build) — or, alternatively, selling it once we close above the initial low on the way back up. This makes a lot of sense in the current environment, because it can be expected that a short position will have gained a considerable amount of value when reaching exit target #2 due to the wide price range.

Good luck with your trading, and thank you for reading!

David

Browse Recent Blog Posts

If you like what you are reading, please consider subscribing – thank you! Your support is greatly appreciated.