Finding Winning Stocks During a Market Correction
Updated: 6 days ago
Finding Winning Stocks During a Market Correction offers a useful case study in turning market observations into repeatable trading rules. This updated guide preserves the original Financial Wisdom analysis while separating practical lessons from exceptional results and hindsight.
In This Guide
Key lessons and practical rules
The original Financial Wisdom guide and media
Evidence, limitations and risk controls
Frequently asked questions
Related guides and authoritative sources
Key Takeaways
Translate the central idea into objective entry and exit rules.
Test the method across different market regimes and include costs.
Use price, volume and market context without treating any signal as certain.
Define invalidation and position size before entering.
Original Financial Wisdom Guide
Background and Core Ideas
What are the characteristics?
Corrections in stock markets are interesting times for traders. Most experienced traders are completely out of, or shorting, in free-falling markets. They either have blanket rules for exit or they get stopped out of each of their positions as the market turns red.
Once in cash, these traders don’t sit relaxed. They keep on following their daily routine to identify turning points and hunt for the best candidates to trade when the markets stabilize.
However, there are unpredictable wait times when traders just have to follow their routines and not act, or act small to preserve their capital. Markets generally don’t go down all at once and there could be a few legs of downtrend before the market finally bottoms and reverses.
This is why corrections have to be handled carefully. You can always confuse an interim bounce as a reversal and it will come right back at you. If you are aggressive at such times, you could lose your financial and mental capital. You go through a few such phases and likely give up when the market actually turns.
(S&P 500 - Higher lows and break of resistance in July 2022, market bottom?)
How do corrections function
Markets go down in phases for varying lengths of time ranging from a couple of months to a few years, depending on the kind of excesses built, the reasons for the fall, and the support that the market is getting.
For example, the dot com bust lasted close to two-and-half years, while the global financial crisis fall lasted for a lesser time even when it was a much bigger crisis. That was because the Central Banks supported the markets with easy liquidity. How all the factors come together to move the markets is clear only in hindsight.
Practical Checkpoint
Define the setup, entry and invalidation level before acting.
Compare the potential payoff with risk-reward planning.
Set the trade size using consistent position-sizing rules.
Rules and Practical Application
That said, tracking the news is not the best way to determine the correction bottom. Most of the time it takes hard work and needs analysing hard data like sentiment indicators, market breadth, and how individual stocks are performing.
At the trough, the sentiment is extremely bearish, breadth is tilted completely towards losers, the news is all bad and there are only a countable number of stocks trading above their long-term moving averages. Such extreme bearishness generally makes the bottom.
As the market turns, the bad news stops impacting the market, the breadth starts improving, and stocks reclaim their long-term moving averages but the market participants are still in disbelief.
All you have to then do is follow the data and turn off the news and hearsay. Data is the best indicator of the upcoming uptrend.
Follow the stocks and sectors
Some sectors and stocks refuse to go down with the markets in the later legs of the fall. They start to make higher lows when the markets are making lower lows, or they display extraordinary relative strength compared to the market and keep on hitting new highs when the market takes a breather from the fall.
For example, below is Amazon’s chart from 2002. The stock price (candle chart) of Amazon bottomed before the market and did not hit a new low as the Nasdaq Composite (Orange line) hit a new low. Amazon went on to deliver 250%+ returns in a year after the market bottomed, while the NASDAQ delivered 75% return.
If you see many stocks displaying such characteristics, it’s an indication that the downturn is losing steam.
Apart from looking for such behaviours, look for stocks that are hitting new highs and for sectors or groups these leading stocks belong. If there are stocks and sectors that are making newer highs before the markets, those can very well be your winning set of stocks to play the first leg of the uptrend.
Evidence Check
Is the sample broad enough to include difficult markets?
Do the results include spreads, fees, slippage and failed signals?
Could hindsight, survivorship or selective examples explain the result?
Evidence and Examples
Some of these sectors will start performing right away after the weight of the market is lifted, while some will set up later and move fiercely while the market is still stabilizing.
All you have to do at this point is to keep track.
Once you have enough sectors and stocks displaying constructive price behaviour, you can get ready to act big and make the most of the move.
Take progressive exposure
If you see tradable opportunities after the market bottoms, you must not get all in. Instead, you must take progressive exposure starting with a small part of your capital to test the waters. If those small positions start working, you may progressively increase exposure and gradually move to be fully invested.
Alternatively, if the positions don’t work, you must not increase the exposure and keep trading small until you see trades working.
Look for low risk entry points
You must always look for entry at points where the risk is small and you lose a small sum when you get stopped. That way even if you get stopped a few times in a row on small exposure, you wouldn’t lose too much of your capital and you wont need huge gains to recover.
(Don't let the losses grow)
Risk and Limitations
For example, as of today (July 2022) I'm using 10% position size, and if my average stop loss is 10% I would only be risking 1% of total equity. Too big a position size and/or too big a stop loss and testing the waters could be very expensive.
The idea is to not lose your bull market gains in corrective markets and preserve your capital. You must keep following stop-loss discipline at all times irrespective of how strongly you feel about the opportunities and the set-ups you are trading.
The Final Word
Bear markets or corrections can take an emotional toll on the trader’s mindset, which will make you do dumb things at the worst of times. This is why it’s essential to go slow and lose less to maintain sanity.
The markets present many opportunities each day and, as a trader, you must preserve your financial and mental capital to benefit from these opportunities as and when they come. Trading systematically with discipline is the best way to maintain longevity in trading. That’s what every trader should strive to do.
Remember, market drawdowns eventually present potentially life changing opportunities when they turn, just be ready for when they do.
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Summary of the Original Guide
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Practical Limitations
Historical examples, book claims and indicator results are educational illustrations rather than forecasts. Outcomes depend on the market, timeframe, data, transaction costs, financing, taxes and execution assumptions. Test complete rules across varied conditions and define the maximum acceptable account risk before taking a position.
Put This Into Practice
These ideas become more useful when selection, entry, stop placement, position sizing and trade management form one repeatable process. The Financial Wisdom Trading Blueprint connects those decisions in a practical weekly framework.
Frequently Asked Questions
Does this strategy guarantee profitable trades?
No. It provides a framework with uncertain outcomes and must be tested with complete risk and execution rules.
What should be defined before an entry?
Specify the setup, trigger, invalidation level, position size and conditions for managing or exiting the trade.
Further Reading
References and Further Reading
Educational information only. Trading and investing involve risk, including the possible loss of capital. Examples are illustrative, not guarantees of future performance, and nothing in this article is personalised financial advice.
About the Author
Written by Gareth, MBA
Gareth, founder of Financial Wisdom, has more than 30 years of personal trading experience. He competes in the United States Investing Championship, creates award-winning trading content and has been featured in Technical Analysis of Stocks & Commodities.
I wonder whether there's a way to apply relative strength in identifying possible opportunities?
Use an index (s&p 500) and compare an individual stock against that index price movements.