In the past week and a half, the ASX200 corrected from a high of 6120 to 5785 and has rallied back to a high of 5940. However, it is rare for the market to make such a large correction and rally back to over 6000 in such a short period of time. There is a high probability that this is the top of the range and the market will consolidate from here.

Update 3rd March 2017 – The ASX200 almost reached 6100 before correcting – which was quite extraordinary. With the market closing at 5928 on Friday due to negative news coming from the US (Trump trade war / 25% tariff on steel, 10% on aluminium), we expect more downside from here potentially down to 5800. How the market reacts from this point is critical. If it holds, we can expect consolidation around 5800-6000 area; if it doesn’t, we could be seeing another high volume down to 5600. Having said that, I hope you have some dry powder available to pick up some bargains in this dip. If you want to know what you can do to make a profit from the next leg down, consider selling insurance to scared investors by selling put options. There is a CBA shares Put option example here from the last dip which would have closed with a 50%+ profit in late February.

To put this into context, when markets fall, there are generally three types of scenarios.

Market Pullback

The first type is a market pullback. This is where the market takes a breather as short-term long positions take profit. These types of pullbacks generally don’t break moving averages such as the 20, 30 or 50 moving average. On the supply and demand imbalance, there is usually just a small lack of demand and non-aggressive supply. The small lack of demand is due to prices rising a bit too high and participants waiting for a pullback to make an entry, whilst the non-aggressive supply is caused by slight profit taking, but not risk off.

This generally causes a shallow pullback in the 5% or less range on low volume and the ASX200 tends to make new highs within a few days to weeks.

Market Correction

The second type is a market correction. This is where the market participants have a risk-off attitude and medium and short-term participants take profit. These types of market corrections generally break most short to medium term moving averages such as the 50, or 100 moving average. On the supply and demand imbalance, there is usually a high lack of demand and aggressive supply. The high lack of demand is due to participants wanting to exit positions, with no particular appetite to catch the pullback yet. The aggressive supply is due to short and medium positions taking a risk-off position.

This generally causes a deep pullback, in the 10-20% or so range on high volume. The market then tends to rally strongly as bargain hunters come in. However, due to the much higher 10-20% pullback, market participants who have existing losing positions from before the correction will use this rally to further close their positions. The lack of volume can also be attributed to higher margin requirements at most brokers – if you have one, you would have received a notification of higher margin requirements on the February 6th when the ASX200 corrected. We are currently here.

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Market Crash

The third type is a market crash. This is where all market participants, short, medium and long-term participants either hedge positions or close them completely. This will generally breach the long-term moving averages such as the 200 or 250 moving average. On the supply and demand imbalance, there is almost no demand and extremely aggressive supply. This is also where margin calls are triggered and we experience a negative feedback loop of supply as margin calls trigger new margin calls. Margin calls have to sell to cover, so there is indiscriminate selling of any position even if they are underwater.

This generally causes a crash, in the range of 20-50%+ on very high volume. The market will then experience an extremely strong rally in the short term as bargain hunters come in but then consolidate sideways for months to years on very low volume as institutional buyers stay out of the market. The lack of volume can also be attributed to destruction of money due to defaults on margin calls and very suppressed demand due to the lack of margin offered by brokers and banks.

What May Happen Next With The ASX200

At this point, the probability is for the market to consolidate sideways for a number of weeks to months between 5800 and 5900 or so. This means we have potentially reached the high of the range with the market trading at 5930 and we are at the start of a new consolidation.

A good example of this was when the S&P 500 corrected in August 2015. The market didn’t recover back to where it was before the correction for another 3 months. The initial rally was also a bull trap, the market pulled back to almost its previous lows in late September.

The biggest problem is treating a pullback and a correction as the same thing. How market participants react to these two scenarios is fundamentally different. With pullbacks, any temporary imbalance towards supply in the market is an opportunity to buy in. However, with corrections or worse, buying the rally after the pullback is potentially a bull trap unless you buy the ASX200 right at the bottom.