What is a Downtrend?
A downtrend is an overall move lower in price, created by lowers lows and lower high.
A downtrend describes the price movement of a financial asset when the overall direction is downward.
In a downtrend, each successive peak and trough is lower than the ones found earlier in the trend.
The downtrend is therefore composed of lower swing lows and lower swing highs.
As long as the price is making these lower swing lows and lower swing highs, the downtrend is considered intact.
Once the price starts making higher swing highs or higher swing lows, the downtrend is in question or has reversed into an uptrend.
Introduction of Identifying Downtrends
As much as it is important to look out for uptrends when trading, it is equally important to understand and identify downtrends. A trader may potentially save money if they decide to sell off a declining stock.
If many traders decide to sell a stock at the same time, it will result in a sharp decline in the stock price. The stock market is sentiment-driven, and fear of a further decline may result in even further selloffs of a stock.
Some traders that frequently day trade may decide to implement stop-loss orders to protect themselves against a downtrend. A stop-loss order placed with a broker helps a trader sell once the price of the security reaches a certain price. Downtrends can vary from a gradual continuation to a sharp decline. A sharp decline may occur as a result of news-related topics, such as a poor quarterly earnings report or loss of a lawsuit.
A downtrend can be identified and understood through various forms of technical analysis. One simple area of technical analysis is the use of trendlines. Trendlines connect a series of high or low points. The reversal of a declining trendline signals an uptrend.
The majority of equity traders seek to avoid downtrends because they are inherently focused on upward trends and trade long only. Downtrends can be found in every trading time frame, whether minutes, days, weeks, months, or years. Traders look for ways to identify a downtrend as early as possible. Some traders prefer to trade both long and short, so they identify downtrends for new trading opportunities.
Traders recognize that once a downtrend has been established it is best to proceed with caution while entering into any new long positions. This hesitancy exacerbates the downtrend by contributing to reduced demand. Traders who trade both long and short recognize the opposite, a new opportunity to profit from the downtrend.
Short sellers profit from downtrends by borrowing and then immediately selling shares with the agreement to repurchase them in the future. These are known as short positions or short selling. If the asset’s price continues to decline, the trader profits from the difference between the immediate sale price and the lower future repurchase price.
Short sellers add to the price action by entering with sell orders, accelerating the downward trend. Such traders look to profit from the next low swing, patiently awaiting the trend to continue lower.