Downtrends are not as popular as uptrends, as it is uptrends that investors and mutual funds profit from. Yet downtrends are a part of market life, whether liked or not, and learning about downtrends can help you stay out of them, or profit from them. In stock trading, money can be made from being long or being short. When long you profit if the price of a stock rises; when short you profit if the price of a stock falls. While avoiding downtrends will protect your pocket book, participating in downtrends may fatten it. Therefore, traders need to understand downtrends, how they are established, signs they are reversing, and the limitations of charting downtrends.
What Is a Downtrend?
A sustained move lower in a stock’s price could be a downtrend, but it needs to be more accurately defined.
Stock prices move in waves or swings. During a downtrend, the waves lower are larger than the waves high (pullbacks), this allows the price to make progress lower. In a downtrend prices don’t relentlessly drop, instead the price follows a two-steps-lower-one-step-higher type structure.
How Is a Downtrend Established?
Since prices decline via a drop-pullback-drop structure, a downtrend occurs when a stock’s price is making lower-wave-highs and lower-wave-lows. This shows the price is progressing to the downside and establishes the downtrend.
Use stock charts to monitor for such conditions. The low of a major price wave should be below the prior major wave low. Similarly, the high of a major price wave should be below the prior major wave high. When these conditions aren’t met, it is a warning sign that the downtrend is reversing or has already reversed (next section).
Downtrends have varying degrees of strength. Some may move at 45 degrees, some less and others may move almost vertically. A sharp selloff is typically related to news, such as poor quarterly earnings. With a near vertical trend the space between former highs and new highs (and former lows and new lows) can be quite vast.
Downtrends begin and persist for a number of reasons, including fear and speculation. If traders (cumulatively) believe a stock price will continue to decline, they sell the stock in a self-fulfilling prophecy. Fear of further declines forces many traders and investors to sell their equities. Eventually, prices a reach a level that is viewed as a bargain. Buyers become more aggressive than sellers, and short-sellers cover their short positions (buying), pushing the stock back up. This shift in sentiment converts the downtrend to an uptrend.
The stock market exists to provide capital to corporations; the trend of a stock is therefore linked to the outlook for that corporation. While traders speculate, their decisions to do so are often driven by their outlook for the company, economy, government, and foreign policy. If traders are pessimistic on these factors, they will typically sell stock, resulting in downtrends reflected on the charts.
How Is a Downtrend Reversed?
A price downtrend is composed of lower swing highs and lower swing lows, so when these conditions are not satisfied the trend could be reversing higher.
Trends occur across different time frames though; it may be a downtrend on a 5-minute chart, while an uptrend on the 30-minute chart. Similarly it may be an uptrend on the weekly chart, but a downtrend on the daily chart. Investors typically only look at major price swings on the daily or weekly chart. If the trend is down on these time frames they avoid trading; when the price reverses and becomes an uptrend they re-establish long positions. Shorter-term traders, who don’t mind shorting stocks, can potentially profit from up or down trends across all time frames.
Figure 3 shows a downtrend in AT&T (NYSE:T), which reverses and becomes an uptrend. Initially the price is making lower lows and lower highs; when higher highs and higher lows appear the downtrend is over and an uptrend beginning. When this occurs it is time to exit short positions, and initiate long positions.
Monitoring a downtrend for lower highs and lower lows is a sound method for discerning if the downtrend is intact. Another method is to use trendlines. During a downtrend a trendline connects the swing highs. If the price breaks above the trendline, it is a warning sign that the downtrend is weakening. This doesn’t mean the downtrend is over; the event is just an advance warning that the trend has slowed. Use price action (highs and lows) to confirm trendline breaks and reversals.
In Figure 4 the price breaks above the trendline, this in itself doesn’t prove a reversal has occurred. It does provide an early warning sign though, as the price proceeds to make higher highs and higher lows, confirming the reversal and new uptrend.
Charting Downtrends: Limitations
Trend analysis can be subjective – what one person sees another may not. Trends are easy to spot in hindsight, but are more difficult to analyze in real-time. In advance we don’t know if the price will keep making lower highs and lower lows. It is only after the price starts making higher highs and higher lows that we can confirm there was a reversal.
The market also doesn’t move in perfect waves, and can therefore trick us. During a downtrend the price may make a higher high and higher low, indicating the trend is now up, but then proceeds to drop and continue the downtrend.
Some of these false signals, and potential losing trades, are avoided by looking at another time frame. Instead of looking at just one year of price data, look at two or three. You may notice the price wave of concern is not significant from this perspective, and therefore shouldn’t be a major factor in your decision making.
Trends can be profitable while they last, but we can’t predict with great accuracy when they will end.
See Also: 25 Stocks Day Traders Love
The Bottom Line
A downtrend is created by the price making lower swing highs and lower swings lows in price. Downtrends may be steep or shallow, but are still analyzed in the same general way. When the price starts making higher highs and higher lows the downtrend may be over and an uptrend beginning. Trendlines are a visual tool, used in conjunction with price analysis (highs and lows), to confirm trends and anticipate reversals. Trends can be tricky though; easy to spot in hindsight it is difficult to predict when a trend will reverse before it occurs. Traders must remain alert and conscious of changes in price which could affect the direction of the trend.