What Is a Downtrend?
A downtrend refers to the price action of a security that moves lower in price as it fluctuates over time. While the price may move intermittently higher or lower, downtrends are characterized by lower peaks and lower troughs over time. Technical analysts pay attention to downtrends because they represent something more than a random losing streak. Securities in a downtrend seem to be more likely to continue trending lower until some market condition changes, implying that a downtrend marks a fundamentally deteriorating condition.
A downtrend can be contrasted with an uptrend.
- Downtrends are characterized by lower peaks and troughs and imply fundamental changes in the beliefs of investors.
- A change in trend is fueled by a change in the supply of stocks investors want to sell compared with the demand for the stock by investors who want to buy.
- Downtrends are coincidental with changes in the factors that surround the security, whether macroeconomic or specifically associated with a company's business model.
How a Downtrend Works
A security that changes from an uptrend to a downtrend very rarely makes a single instantaneous changes from one to the other. Instead the price action in an uptrend shows signs of strain and then the downtrend incrementally begins. Both upward and downward trends are marked by their peaks and troughs (also referred to as swing highs and swing lows), and the general direction they appear to be proceeding. The following illustration shows a series of peaks and troughs (peaks are even numbered, troughs are odd).
The dynamic shown in this illustration is similar in nature to almost all trend changes from upward to downward. Though specifics vary in each instance, three characteristics of this change are common:
- The price action falls below the most recent trough (shown in points 1-3)
- The next peak fails to rise higher than its predecessor (points 3-5)
- The downward trend increases its likelihood of continuing (points 5-7)
The first characteristic of a downtrend marks a point in the price action where supply exceeds demand. The number of available sellers and the quantity of the security they want to sell is more than the number of ready buyers and the quantity they want to buy. Somehow market participants have, as a majority, no longer accepted the idea that this security should be priced as high as it is.
The second characteristic indicates the increasing number of market participants that, though previously undecided, have become convinced during the recent peak of price that they must no longer own (or own as much of) the security. The number of sellers increases simultaneously with the number of buyers decreasing.
The third characteristic is usually accompanied by news or new information that confirms the suspicions of those who determined to exit, or no longer consider buying, the security. Even more buyers back away and even more sellers become eager to take profits or limit losses.
The majority of 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: minutes, days, weeks, months, or even years. Traders therefore 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 within their preferred time frame, they should be very cautious about entering into any new long positions. This exacerbates the downtrend by contributing to a reduced demand. Long/short traders recognize the opposite, that this is now their opportunity to profit on the downtrend.
Since short sellers seek to 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. Since they add to the price action by entering with sell orders, this too exacerbates the downward trend. Such traders look to profit from at least the next swing lower, maybe more if they can be patient and the trend actually does continue lower.
Often times, traders use technical indicators and chart patterns to identify and confirm downtrends. Moving averages, for example, can be used to identify the overall trend. If the price is lower than a moving average, the stock is likely to be in a downtrend, and vice versa for an uptrend. Technical indicators such as the relative strength index (RSI) or the Average Directional Index (ADX), can also show the magnitude or strength of the downtrend at a given point in time, which can help when deciding whether or not to enter a short position.
Example of a Prolonged Downtrend
The example of the lengthy downtrend in General Electric Co. (GE) stock prices is instructive to review. This price action accompanied a growing awareness that the company's troubles were deeper than originally anticipated, and that layoffs, spinoffs, plant closings and product cancellations were signaling a sea change in the economic environment—one that GE was not prepared for.
In this chart, the stock makes its final peak followed by the next trough moving lower than the previous trough (as shown in the inset). This lower trough coincides with the moment that supply of stock that investors want to sell has outnumbered the demand that investors have to buy the stock at these prices. This initial sign of weakness (an example of the first characteristic mentioned previously) was not accompanied by widely spread news of the company's troubles, though investors determined for themselves that the company's prospects were not as optimal as previously thought.
The lower peaks and troughs that follow mark an extended downtrend lasting more than two years—and during a time when the rest of the market was generally moving higher. Traders that had taken a bearish stance on the stock following the breakdown from the first trough would have found many opportunities for profitable trades. Alternatively, long traders may have locked in their profits at the beginning of the downtrend and re-entered their long position after the stock showed signs of a rebound.