Definitions are important. That’s why we have dictionaries – they create standards that we all understand. Instead of turning things into 50 shades of grey (not talking about the book), definitions turn things into black and white. Black and white is exactly what we need when we invest. We either need a “sell” or a “buy” signal. We can’t effectively use “maybe you should buy if…”
Sites like Investopedia and Wikipedia have already defined practically every trading term, from “trend” to “correction” to “pullback”. The problem is – I don’t like using their definitions. Why? Because their definitions always overlap and are not clear. According to Investopedia, a “correction” and a “pullback” are practically the same thing, except a correction is slightly bigger than a pullback percentage-wise.
Great. “Slightly bigger”. How much bigger is “slightly”?
That’s why every single investor and trader needs to create a set of definitions. Define exactly how big a pullback should be, and define exactly how big a correction should be. By creating a definition, you are defining a problem. Defining a problem is the hard part – the easy part is finding the answer. That’s what they teach you in data mining classes (for you math majors out there).
When someone else has already defined trading terms, it’s easy to say “oh, I get it.” Understanding the terms that other successful investors and traders have defined is easy. Defining the terms for yourself is hard but necessary. So how do you define trading definitions?
How To Define These Terms
In this post, we’re going to focus on 3 main terms:
How you define these terms completely depends on what term period (time frame) of an investor or trader you are. Are you a long term investor, short term investor, or medium term investor? How do you even define “long term” or “medium term”? By defining these words, you’re clearing up any possible confusion.
For the super long term investor, a trend can last years or decades. A “correction” could be a 20% decline in the market. A pullback could be a 5% decline. So how you define these terms completely depends on how you invest.
Personally, I look at daily bar charts (the price pattern each day). The way I define my terms is by looking at the price charts on my screen. I see patterns repeating themselves. To define certain terms, you must look at how history has defined these terms and how has history repeated itself? What are the commonalities between these patterns?
By categorizing the commonalities between these patterns, I am in effect creating a set of definitions that I can use for predicting the market’s future price. For example, I’ve sifted through 13 years of stock market history for the S&P 500. Based on my analysis, a pullback is 2% and a correction is 7% to 10%. A trend is defined by the period between one correction and the next correction.
Why You Need Standardized Definitions
Standardized definitions offer several huge advantages.
I’ve noticed a really funny thing about a lot of investors – they always want to “buy on the dip”. When the actually dip comes, it’s not a dip. It’s the mother of all avalanches. The market crashes big time. Instead of getting out of the market like a sensible person would, they use the excuse “I’m a long term investor” not because they’re actually a long term investor, but because they can’t fess up to their mistake.
Definitions are like an investment model – they force you to follow your investment plan step-by-step. If the word “long term investor” isn’t in your dictionary, then you wouldn’t think twice about holding onto a losing position. If a pullback turns into a correction, I will get out of the market to avoid further losses and not hang onto a losing position.
Spot A Trend Before It Happens
Let’s assume that my definition of “correction” is 10% and “pullback” is 2%. If the market falls 2%, you’ll think “OK, this is just a pullback. I will hang in here and just sit out the pullback”. However, if the market continues to fall and is now down 3%, then you can reasonably predict that this is not a pullback, but a correction. The market is now outside of the range you defined for the term correction and will fall another 7%. Thus, you might want to sell now and save yourself 7%.
Clear definitions allow you to catch a trend or a market movement when the movement is in its early stages. Doing so can save you a lot of money. Instead of looking back at the market’s past and saying “oh, that was a correction”, you can anticipate things before they happen. As investors and traders, we make money by buying or selling before a trend materializes.