What is a Downtrend
A downtrend occurs when the price of an asset moves lower over a period of time. While the price may move intermittently higher or lower, downtrends are characterized by lower peaks and lower troughs over time.
Notice how each successive peak and trough is lower than the previous one. For example, the low at Point 3 is lower than the low at Point 1. The downtrend will be deemed broken once the price closes above the high at Point 4.
BREAKING DOWN Downtrend
Many traders seek to avoid downtrends because they can adversely affect the value of any investment. A downtrend can last for minutes, days, weeks, months or even years, so identifying a downtrend early is very important. Once a downtrend has been established (series of lower peaks) a trader should be very cautious about entering into any new long positions.
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.
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. Momentum indicators, such as the relative strength index (RSI), 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.
Examples of Downtrends
Let's take a look at an example of a downtrend in General Electric Co. (GE):
In this chart, the stock makes a series of lower peaks and troughs between January and March before bottoming out in April. Traders may have taken a bearish stance on the stock following the breakdown from the 50-day moving average and then shorted the stock until it broke back above the 50-day moving average in late-April. 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.