Market “crashes”Â are aÂ popular subject for consideration during any period of general market weakness. History has shown, however, thatÂ markets in aÂ correction do not typicallyÂ experience an extreme downside “crash”Â similar to what was witnessed in 1987. Rather, the correction unfolds as a series of downside moves which increase in volumeÂ and reverse after a capitulation or flush-out. Between this series of downside moves are bounces which decrease in volume and reverse as the market hits a key resistance level.
At this pointÂ in the currentÂ correction, it seems apparent that the very best traders have probably stayed long and calm (with hedges and strategic, calculated sells) while others were building short positions early enough to be deep in the money.
My sense is thatÂ the rest of the unwashedÂ have sold indiscriminately and bought randomly and have probably timed(poorly) their dip-buying and shortingÂ in a way that ensures maximum psychological pain. Inevitably, the market will move in the opposite direction.
The differences between the great traders and the rookiesÂ isÂ their understanding ofÂ what is probable andÂ likely from a historical perspective, and their ability to position themselves, unequivocally, based on theirÂ determination thatÂ the market is going to behave as it typically has, or whether it isÂ going to do something brand new.
Even during the average pullback of the last 5 years the market has bottomed, bounced, and then made another leg down before a capitulation event occurred. TheÂ indexes in the above charts which show the 1998 correction also exhibit the same behavior, except on a larger scale. A trader who believes that “things are different this time” is either looking forÂ a V bottom or a non-stop drop. Neither is likely, although both are possible.
What is likely is that there will be a sustained bounce, followed by more downside. This patternÂ continuesÂ untilÂ the market eventually reverses on a high-volume capitulation day.
If future market events unfoldÂ similarly toÂ past events, then longs will see higher prices, soon. Shorts who have established positions over the last several days willÂ get squeezed. As prices rise, some longs will believe that the rise will be sustainable and will notÂ sell; they might even add positions.Â Some shorts will believe that a V bottom is occurring and will cover. Both will likely lose money as their psychology eats away at their convictions, and the market reverses for a second leg down.