Downtrend – How to Spot it and How to Trade it

Downtrend - learn how to spot it and how to trade it

In today’s volatile world, financial security is becoming more and more of a prominent issue for all of us. We need to figure out how to invest out money so as to milk the good times for all they are worth and to ride out the bad times till they are over. We also need safety nets for emergencies as well as a nice little nest egg for when we are well past our primes. Additionally, as automation and artificial intelligence keep advancing into the workplace, our jobs are becoming more and more at risk. As a matter of fact, 47 % of our jobs may be overtaken by smart robots within the next two decades according to Oxford University researchers; if that isn’t enough incentive for you to start investing your money, I don’t know what is.

Unfortunately, making good financial decisions is easier said than done, and it is easy for you to lose all your life savings if you don’t know what you’re doing. Therefore, the first investment you should make is in your education: learn how to read the market along with the specific direction a financial asset is taking.

how to spot a downtrend and how to trade it

Taking the first step in your education, we will discuss how to spot a downtrend plus what to do when you see one. Honing this ability will help you minimize your losses when the market takes a dive, and if you get really good at spotting downtrends, you can make huge profits off of it.

what you will need for this journey?

Before beginning our financial journey, we need to take a few things along with us: we need to familiarize ourselves with the lingo used by financial analysts as well as the tools they rely on. Not only will this facilitate matters for us, it will also help you in all your future excursions.

Another thing you need to know is that there are two main roads we can take: that of fundamental analysis and that of technical analysis. Fundamental analysis studies the asset itself and tries to compare the asset’s inherent value with its market value, whereas technical analysis is more concerned with the market price of the asset and how that’s changed over time. Throughout this article, we will be focused on technical analysis. Nevertheless, you should also explore fundamental analysis and learn how to combine both approaches

1. Important definitions:

a. technical analysis:

Technical analysis tracks the history of price movements in addition to the volume of trade, while completely disregarding the underlying asset. The main idea is that the price of an asset should ideally reflect all the relevant information about said asset. Moreover, prices of assets tend to move in what’s known as a trend. For example, if a price is going up, it will probably keep going up for a while before changing direction. Over and above, trends tend to be predictable, due in part to the fact that a main determinant of price is how investors and traders react to fluctuations and new information. These reactions aren’t that hard to anticipate, thanks to historical records.

b. Time period:

Seeing as technical analysis studies the price movements of an asset over a period of time, it comes as no surprise that we need to first define our period of time. For example, we could study how the price of an asset changes every day versus how the price of the same asset changes every hour. In the first scenario, our time period is a single day, while, in the latter scenario, our time period is an hour.

c. Price point:

A price point is basically the price of an asset at a moment in time. For any given time period, technical analysts hone in on four special price points:

i. Opening price: at the beginning of a time period, the price of an asset is recorded and dubbed the opening price.

ii. Closing price: at the end of a time period, the price of an asset is recorded and dubbed the closing price.

iii. High price: during a time period, the highest price an asset reaches is recorded and dubbed the high price.

iv. Low price: during a time period, the lowest price an asset reaches is recorded and dubbed the low price.

Let’s take a look at an example:

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Suppose that we have been studying the price of gold over a time period of a day. On the 27th of March, an ounce of gold cost 1247.20 dollars at the beginning of the day, which is the opening price. Conversely, at the end of the day, an ounce of gold cost 1258.8 dollars, which is the closing price. During the day, the highest price an ounce of gold attained was 1264.2, which was the day’s high price. On the other hand, the lowest price an ounce of gold hit that day was 1247.20, which was the day’s low price.

If you’ve been paying attention so far, you’ll have noticed that the opening price and the low price of gold was the same that day. This shows that on march 27th, the price of gold kept increasing that day, and the demand was higher than the supply.

d. Trends:

It is not particularly easy to agree on a definition for trends, but, all the same, here it goes: A trend is the general direction in which an asset’s price is headed. Naturally, the price of an asset rarely skyrockets in a single direction. Instead, the price of an asset tends to move up and down, with the general direction being consistent for a period of time. Bear in mind that this applies to any publicly traded security or commodity, including the Forex.

Trends can be divided in one of two ways: direction-wise or time-wise.

When it comes to directions, trends can go in one of three ways:

• An uptrend is when the price of an asset is generally increasing. It is usually marked by the fact that each high and low is higher than the one preceding it.

• A downtrend is when the price of an asset is generally decreasing. It is usually marked by the fact that each high and low is lower than the one preceding it.

• Sideway/ horizontal trends is when the price of an asset is generally neither increasing nor decreasing. In this case, an asset’s price might fluctuate, but its average price is more or less constant.

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On the other hand, analyzing trends according to their time length gives you three possibilities:

• A short term trend is one that takes place in less than a month.

• A medium term trend is one that takes place in a time frame between a month and three months.

• A long term trend is one that takes place for longer than a year.

You should bear in mind that the longer the trend, the more significant it is: it can be more trusted, and a reversal of this trend is a much more meaningful than the reversal of a shorter one. Also, each long trend consists of medium trends, which in turn are made up of short trends. It is for these reasons and more that trend analysis plays a huge part in technical analysis. If anything, the whole objective of technical analysis can be summed up in one notion: forecasting trends with a high level of confidence.

e. Position:

Let’s agree that a position is where an investor situates themselves relative to a particular asset. This will be made much clearer through the use of examples:

• An investor who’s secured a buy position intends to buy a specific asset at a particular price.

• An investor who’s secured a sell position intends to sell a specific asset at a particular price.

• An investor who’s secured a long position intends to bet on the asset. They plan to buy an asset and hold onto it for a period of time till it appreciates in value.

• An investor who’s secured a short position intends to bet against the asset. They plan to sell the asset today for its fair market value. Afterwards, when the asset depreciates in value, the same investor will purchase the asset at the reduced price, and their profit will be the difference between their sell price and their later buy price.

2. Important tools:

Having gathered some important definitions, let’s move on and construct a few useful tools:

a. Charts:

Our current focus on historical data compels us to consider ways of presenting this information in a more concise and digestible form. This is where compact visual representations, a.k.a. charts, come in.

There are numerous kinds of charts, but, for our purposes, we will focus on candlestick charts only.

candlestick chart
The vertical axis of a candlestick chart represents the prices, while the horizontal axis denotes the time period. The horizontal axis could display how the asset changed price over a period of hours, days, weeks, months, or years, depending on the set time period.

However, the true value of a candlestick chart lies in the amount of information each candle gives off. Each candle is composed of a body and a wick and has a unique color that gives off a particular meaning hence giving you all the price points you could possibly need. To elaborate further, I’ll explain each aspect separately:

• The candle’s color symbolizes whether the price of the asset appreciated or depreciated over the time period of the candle. Assets that appreciate in value are usually symbolized by a body that’s colored green or left empty. On the flipside of the coin, assets that depreciate in value are marked by a candle body that’s colored red or black.

• The candle’s body represents the opening and closing price of the asset over the time period. If a candle has a green body, meaning that the underlying asset increased in value, then the bottom of the body represents the opening price and the top of the body represents the closing price. Naturally, the opposite would be true had the candle had a red body.

• The candle’s wicks represent the high and low prices of the time period. Needless to say, the upper wick represents the high price, regardless of the color of the candle. The same applies to the lower wick.

Besides giving off all the necessary price points pertaining to a time period, candlesticks tend to form patterns that can allude to future price movements. For example, a doji, which is a kind of candlestick, may signify something, yet a hammer can be screaming something else entirely. Moreover, groups of candlesticks can give off their own meanings also: a bullish engulfing and a rising sun are two completely different patterns, but they may have similar implications.

Nevertheless, you don’t have to worry about all of this; I will not ask you to remember any patterns or to memorize any shapes. Rather, I’ll give you a simple rule of thumb for you to follow:

Try comparing the body of a candle with its wicks. If the body is much larger than the wicks, then this signifies the certainty the market has in the value of the asset. As a result, it is a safe bet that whatever trend the asset is experiencing will continue. Conversely, wicks that are much larger than the body exhibit uncertainty, and there is a large possibility that a current trend will reverse. Of course, there are several shapes that go beyond this simple breakdown: a candle could have a long lower wick, a relatively small body, and a non-existent upper wick (in which case the candle is called a hammer). This type of candle may signify something unique, depending on the context. Yet, for all intents and purposes, our simpler rule of thumb will serve us just fine.

b. Support and resistance levels and trend lines:

When the price of an asset fluctuates, there is always method to the way in which this fluctuation happens. The price usually exhibits a certain sense of constraint that can be identified through support and resistance levels. In other words, a support or resistance level is a line which the price has been unable to break, despite trying more than once. So, a support is a line that prevents the price from dropping beyond a certain limit, and a resistance stops the price from rising above a certain limit.

The significance of a support or resistance line can be attributed to its predictive capabilities: when you see the price of an asset approach a support or resistance line, you can bet that the current trend is bound to reverse. In addition, should the price break through this support or resistance, the line’s role will be reversed. To put it in more solid terms, a support level that is broken becomes a resistance level, and the opposite tends to be true.

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So “how do we identify support and resistance levels?” I hear you say. Well, there are several methodologies:

• By drawing horizontal lines that touch the price chart in more than one place, we can discern support and resistance levels. Interestingly enough, round numbers tend to play a big role in this exercise; history tells us that round numbers tend to be excellent support and resistance levels. This may have something to do with our innate psychological dispositions plus our affinity for round numbers.

• Another tool is the use of Fibonacci retracement levels, but we won’t really delve into them here.

• You can also find support or resistance levels by drawing trend lines. Trend lines are lines that aren’t necessarily horizontal but confine the price chart one way or another. You can draw them by finding several reversal points that lie on the same straight line. Furthermore, you can draw a channel should you be able to draw a support trend line along with a resistance trend line.

(Click the image to see it full size)

Obviously, all of this seems good and well, but how can we have any confidence in these support and resistance lines? After all, we are the ones who draw them. Now seems the perfect time to introduce the concept of IRATE criteria, which are used to judge the dependability of a support or resistance line. IRATE stands for indicators, round numbers, age, and tested. You don’t have to know all of these criteria, yet it doesn’t hurt to at least understand most of them:

Indicators:Momentum indicators, or forex trend indicators, give us clues about how strong a trend is as well as how likely it is to continue. Some examples of indicators are moving average crossovers, oscillators, and double Bollinger barrels.

Round numbers:As mentioned earlier, round numbers usually play excellent support and resistance levels. Therefore, you should have much more faith in a support level at 50 dollars than another support level at 47.23 dollars.

Age: Just as longer trends are more significant than shorter ones, older support and resistance levels are more significant than newer ones.

Tested: When we ask ourselves how tested is this support or resistance level, we are trying to investigate how many times this level was able to halt the progress of the price. The more times the support or resistance level held firm, the more faith we have in it.

c. Other useful tools:

Having answered fundamental questions such as what is a trend? What is a trend line? How to identify a trend’s performance? How to draw a trend line? We can now build off of this information in numerous ways:

• We can choose to adopt trend following strategies, where we patiently wait and see where the market is heading and then ride that wave. This is known as using trend trading systems, and it is a valid way to play the market.

• For the more diligent among us, there are numerous chart patterns that derive their shape from their trend lines: head and shoulders, double top, and triple top, to name a few. Each chart pattern produces a market trend signal, if you will, that notifies traders of the next direction the current trend will take.

d. A platform to observe your assets from:

Apart from the knowledge, you will also need the technical tools that will enable you to observe your investments in action. If you choose to invest in the forex market, then I suggest you look for a good platform to trade on as well as monitor your money, such as Meta Trader 4. Conversely, if you choose to invest in the stock market, you’re better off depending on a reliable website like stockmarketwatch.

Time to go on your journey:

It hasn’t been an easy journey so far, but now that we have all the prerequisite information to start targeting downtrends, let’s take a look at what actually needs to be done:

1. Define your objectives:

Before you embark on your hunt, you need to be clear on a few topics:

• How much money do you have? How much of it are you willing to risk?

• How much risk are you willing to expose yourself to?

• Do you want to invest in a few assets or do you want to play the general market?

• How important is it for you to beat the general market?

Answering these questions may require you to include your significant other in the discussion.

2. Begin your search:

Depending on the objectives you’ve stated in the previous question, you can either choose to follow the progress of a few assets or choose to closely monitor the general market. In both scenarios, keeping a watchful eye is only part of the equation; you need to know what to look for.

I will suggest a strategy called price action trading, where you trade based off of the price itself. It is a simple strategy that is suitable for every beginner:

• Start by drawing the main trend lines. This should give you a much clearer view of where the asset is headed. You can try drawing horizontal support and resistance levels or more oblique trend lines. You should just remember the IRATE criteria in all cases.

• Pay attention to each individual candle, and try to figure out what it is telling you.

• Bear in mind that a single signal on its own is not nearly as potent as a group of signals taken together. It’s the same difference between judging a painting from just looking at the corner part versus taking the whole painting into consideration. Consequently, the more signals you are able to incorporate, the more of a holistic picture you’ll see.

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3. Identify the downtrend:

There are two types of downtrends to look out for:

• The first is the continuation of an ongoing downtrend.

• The second is the reversal of an uptrend.

Each type of downtrend can be identified in different ways:

• When an asset is in the middle of a downtrend, it isn’t that hard to spot. The trick is to know whether this downtrend will continue on for a while. Therefore, you have to answer questions like is the price close to its support levels? Do the candles display any sense of uncertainty in the market? If the answer to either one of these questions is yes, then you’re better off letting this downtrend go as it might reverse soon.

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• When an asset in the middle of an uptrend, you should ask yourself very similar questions to the ones above: is the price close to its resistance levels? Do the candles display any sense of uncertainty in the market? If, and only if, the answer to both these questions is yes, then the asset is probably about to reverse and experience a downtrend.

4. Trade the downtrend:So how do you get started:

In this article, we’ve covered a lot of ground, which should give you the ability to start trading right now. However, there is a world of difference between understanding something and being able to apply it in real life. Hence, what you need now is practice.

My advice for you is to start small and experiment. You can start by looking for cheap stocks to buy, like penny stocks. Although penny stocks are usually unstable investments, think of them as practice for the real thing instead: finding trending penny stocks is no mean feat, and it can prepare you for bigger game. Pretty soon, you’ll be spotting stock trends like a pro.

Another thing to be wary of is how volatile the market can get. It happens. The trick is to have a system and stick to it. So long as you don’t panic, you’ll be fine.

In this tutorial, you’ve learnt the basics of technical analysis as well as how to spot a downtrend and trade it. These skills can prove instrumental when investing your money, especially when it comes to timing your entry or exit.

Please let us know what you think, and if you have anything to add, feel free to do so in the comments.


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