Warrior Trading Blog

How To Identify and Trade a Downtrend

Downtrend

In stock trading, you can make money from an uptrend or a downtrend.

Downtrends tend to move faster than uptrends, which is why you will find some traders who opt to only short sell stocks in order to capitalize on the quick price action.

Research shows that stocks can trend more than 30% of the time. The rest of the time, the stock moves sideways.

Want to know how to identify and trade a downtrend?

In this post, we discuss what a downtrend is, and how to spot and trade them.

What Is a Downtrend?

A downtrend is when price action in a stock is moving lower over a period of time and is most recognizable by prices creating lower lows and lower highs.

Stocks in a downtrend continue in a trend down until certain market conditions change the direction. A downtrend is typically reversed by the supply of shares investors are planning on selling compared to the demand of investors who want to buy the stocks

What you need to know is that a downtrend is composed of two types of price waves. They include:

  • Impulse  
  • Correction  

For example, if Company A stock price was $13, then drops to $12.50, then rallies to $12.75 and again falls to $11.75. These price movements will create a price wave. What you need to know is that Impulse price waves are larger ($12.75 to $11.75), while corrective waves are much smaller $12.50 to $12.75.

Trends form when the stock price makes progress. It can either be in one direction or another. If the impulse wave moves down, followed by a corrective wave up, it means the stock price has made a downside move.

In stock trading, a downtrend will continue as long as the impulse waves down and corrective waves up.

Key Characteristics of a Downtrend

Several things characterize a downtrend which is easily recognized in charts as you can see below:

Lower Peaks and Troughs

Lower peaks and troughs characterize downtrends with lower lows and lower highs taking place as you can see in the graph above.. A peak refers to the highest point between a contraction and an economic expansion. A trough is also a stage in the business cycle, just like a peak.

But, unlike a peak where activity is increasing, in a trough, activity or prices are bottoming. A trough in a business cycle typically marked by layoffs, declining business sales, and earnings as well as higher unemployment.

It’s also important to note that trends can form on different time frames. You can have intraday trends as well macro trends on daily and weekly charts.

News Catalysts

News catalysts is another characteristic that can push stocks into a downtrend. Take the example of CBD stocks. When the US Farm Bill passed legislation to legalize the industrial hemp growth, it sparked interest among investors.

Why? There was a massive chance for the legalization of medical and recreational marijuana. The news had a significant effect on CBD stocks, which resulted in an uptrend. If it were negative news, for example, medical marijuana was not legalized, it would affect CBD stocks.

This would result in a downtrend where a majority of investors will be selling, but a few investors would be buying. Apart from news catalysts, earnings reports and changes in management can result in a downtrend too.

Increase in Market Participants

When the stock price goes downs, the number of sellers increases, which means supply exceeds demand. The increase in market participants who are now convinced that the declining stock price is temporary will begin to rise. As such, the number of buyers buying the stock increases while the number of sellers decreases.

How to Trade a Downtrend

A downtrend occurs across all assets and time frames. Traders can trade them over longer-term time frames such as daily, weekly, and monthly or short-term charts like a tick and one-minute charts. What you ought to know is that the same trend trading concepts apply whether the trader is looking at a daily, weekly, or monthly chart.

If a trader is viewing a one-minute chart, traders seek trades with small trends while on a weekly chart, the trader seeks trades that last for months or even years. In stock trading, a majority of traders avoid downtrends.

Why? They focus on uptrends. Since downtrends are in all time frames, traders identify the lower peaks and troughs early. By identifying downtrends, traders can discover new trading opportunities.

Tools

There are several tools traders can use to identify or spot downtrends. One of those tools is a stock screener. While a stock screener lacks a specific tool for downtrends, you can use features such as Day Gainers, technical, and fundamental indicators such as moving averages or relative strength index. You can also identify downtrends using volume and volatility.

Apart from the stock screener, use the line graph of a stock chart. If you look at a line graph, you can spot emerging trends. All you have to do is check different time frames. If there are peaks and troughs in the chart, that indicates a trend.

Use trend lines during trend analysis. How? By creating a trend line over a stock chart’s high pivot points or under pivot low points. This is a great visual indicator of resistance and support. It also offers a clue to the direction of the price change and speed.

You also have the Average Directional Index, which can show the strength or magnitude of downtime at a certain point. In fact, the Average Directional Index can help traders decide whether or not to enter a short position.

Short sellers profit from downtrends by borrowing then selling the stock immediately with an agreement to buy them in the coming future. Also known as short selling, traders benefit from the difference between the lower future price and current sale price.

If you are planning on short selling, do so during the corrective wave. Using Fibonacci retracement levels will isolate sections where correction stops and reverses. You can also wait for the correction to stop rallying.

By doing so, you allow the price to move sideways, and when it starts to drop, make a short trade. To manage risk, place a stop loss on every trade. Remember, to exit a short trade with a profit; the prices will need to be lower than what you sold them for.

Trading Tips

  •  Look for prices to reach previous highs but are not able to break through. This is a good indication that buyers are no longer seeing value in the stock and we could be setting up for a move lower.
  •  Use previous highs as a stop location
  •  Look for a break in previous lows to confirm the downtrend
  • Profits should be taken as prices flush below previous lows and stops should be adjusted to the last previous high.

Final Thoughts

There are a couple of mistakes you need to avoid.

First, never fight the overall trend on the higher time frames. If you do so, you may find yourself in a downtrend with no reason to buy. Second, never trade too big. Trends are temporary. Even if they are strong or have a potential for making profits, never risk too much on any one trade.

This is true, especially if you have a small account or just starting. Don’t be greedy. What we recommend is to start small and scale-up. By trading small, you gain crucial knowledge and experience. As such, you will be confident about increasing your trading sizes.

Lastly, take time to learn. To be successful at trading stocks, you need to keep learning. Stay on your toes at all times. How? By keeping abreast of what is happening in the market. To do that, commit yourself to learning and surrounding yourself with more experienced traders.

Best of luck!

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