Most people seek out investments where the price is rising, or about to rise. This style of trading attempts to profit from an uptrend in the price, yet money can also be made when asset prices fall, in what is called a "downtrend." This is accomplished through short-selling. Being able to spot a downtrend saves you money. It alerts you to get out of assets you previously purchased, so all the gains you have made won't be eroded by the falling price.
This article will focus on the price structure of a downtrend, what events cause downtrends to reverse, and how to trade a downtrend.
- A downtrend is defined by lower lows and lower highs on each impulse and correction wave.
- If you're watching an uptrend that starts setting lower lows and lower highs, you may be spotting the formation of a downtrend.
- Downtrends can occur in any time frame, including minutes, days, and years.
- The best way to trade downtrends is to take a bearish position at the peak of a correction, entering the position just as the new lower high is being set.
Price Structure of a Downtrend
If a stock drops from $10 to $9.50, rallies to $9.75, and then falls to $9.30, each of those three movements is a price wave.
To better identify the structure of a downward trend some analysts classify different price movements. For example, some might say that a downtrend is composed of two types of price waves: impulse and correction. Impulse waves are larger: $10 to $9.50 and $9.75 to $9.30. Corrective waves are smaller: $9.50 to $9.75. This is how trends are created, and how the price makes progress in one direction or the other. If there is an impulse wave downward, followed by a corrective (smaller) wave upward, then the price has made overall progress to the downside. The downtrend continues as long as impulse waves occur to the downside, and smaller corrective waves occur to the upside.
The attached chart shows a downtrend. The candlestick chart of the EURUSD forex pair shows the price declining in waves. Another way to think of a downtrend is that it's a sequence of lower highs and lower lows. Moving from left to right on the chart, the impulse waves each reach a lower price than the last impulse, and the highs of each correction also move down.
What Reverses a Downtrend
If a downtrend is a sequence of lower highs and lower lows, or impulse waves to the downside and smaller corrective waves to the upside, a reversal occurs when those criteria are violated.
If the price makes a higher high or higher low, that signals the downtrend is in trouble. For example, the downtrend is in trouble if an impulse wave occurs to the upside and is followed by a smaller down wave (higher high, higher low).
Trend traders adapt to new information as it comes available. The price may move into a downtrend, give a signal the downtrend is in trouble, but then revert to a downtrend again. Or the price could move sideways or into an uptrend. No matter what the scenario, isolating which direction the impulse waves are moving gives you the trend direction. If up and down impulse waves are the same size, then the price is moving in a range (sideways).
When impulses are to the downside, favor short-selling on upside corrections. When impulses are up, favor buying (long) on the corrections lower.
Trading a Downtrend
Trends, both up and down, occur across all time frames and all assets. Trade them on short-term charts (tick and/or one-minute charts) and/or over long-term time frames (daily, weekly, and monthly charts). The same trend trading concepts apply when looking at a one-minute chart or weekly chart. If viewing a one-minute chart, trades are taken to capture small trends lasting hours (rare), minutes, or even seconds. On a weekly chart, traders seek trades that could last months or years.
Once a downside impulse wave occurs (a move lower larger than the prior up waves) it's possible that a new downtrend is starting. Therefore, when a correction to the upside develops, it likely won't rally all the way up to where the impulse wave started (because corrective waves are smaller). Plan on short-selling during that corrective wave, based on the assumption that the price will have another impulse wave lower.
There are multiple techniques for entering a trade during a corrective wave. Fibonacci retracement levels help isolate areas where the correction could stop and reverse. Another method is to wait for the correction to stop rallying, let the price move sideways, and when it starts to drop again, enter a short trade.
Place a stop-loss on each trade to manage risk, and have an exit strategy for taking a profit. During a downtrend, the assumption is that the price will make a new low . . . until it doesn't. Therefore, a target, in order to exit a short trade with a profit, is placed near the former low. In a very strong downtrend (big impulse waves) the target is placed below the prior low. In a weak downtrend (impulse waves barely bigger than corrections) the target is placed just above the prior low.
The Bottom Line
A downtrend occurs when larger waves (impulses) occur to the downside, and smaller waves (corrections) occur to the upside. During downtrends consider short-selling during the correction. Technical tools and strategies help isolate when a correction may be ending. Utilize a stop-loss order to control risk, and plan for how to exit a profitable trade, likely using a price target.
Frequently Asked Questions (FAQs)
Should I exit my trade when the stock is in a downtrend?
Deciding when to enter or exit a trade is up to you and perhaps your financial advisor. It's worth noting that downtrends can occur within larger uptrends, and vice versa, so traders need to determine their time frames. For example, you may notice a downtrend when looking at the past year, so you may exit your trade, but another trader in the same trade may decide to hold because they're watching a larger uptrend in the past decade.
How do I draw a Fibonacci retracement on a downtrend?
To draw a Fibonacci retracement on a downtrend, you start with the peak of the latest correction and drag the retracement to the trough of the latest impulse down. This is the opposite of drawing Fibonacci retracements during an uptrend, but the tool otherwise functions the same.