Put simply, a downtrend offers a great opportunity to profit. You're likely no stranger to the panic that people experience due to changes in the market. However, when people make rash decisions based on fear, you might be able to unearth an opportunity.
Let's take a closer look at the definition of downtrend, how to identify downtrends, whether downtrending stocks are a good investment option for you, top downtrending stocks and how to invest in downtrends. By the time you're done reading, you'll have a better idea of whether you may want to make money off of the underbelly of the market.
What is a Downtrend?
The opposite of an uptrend, a downtrend is a gradual reduction in the price or value of a stock, commodity or a financial market. There are a few types of markets that you can consider downward price movements: bear markets, market pullbacks, reversals, market corrections, recessions and market bottoms. Let's take a look at each type:
- Bear market: Most of the time, the term "bear market" refers to the market as a whole. Bear markets are prolonged drops in investment prices in a continually falling market, usually defined as a decline of 20% or greater. It usually occurs when the number of sellers outnumber the number of buyers. It can last for a long time, though since the year 1966, the average bear market has lasted about 15 months, far shorter than the average bull market.
- Market pullbacks: Market pullbacks, also known as "market retracements," refer to stocks in a bullish trend that experience a steep decline. It's important to note that prices change all the time, so slight changes don't necessarily indicate a market pullback. You should use technical indicators to identify true market pullbacks.
- Reversals: A reversal happens when a stock changes trend and begins moving in the opposite direction compared to previous price action. It's different from a market pullback because it indicates a lengthier period of decline.
- Market corrections: Market corrections are the less-evil stepsister of the bear market. The general definition of a market correction is a market decline of more than 10% but less than 20%, which would inch into bear market territory. In a market correction, an individual stock's share price changes so that it is no longer overvalued.
- Recession: A recession refers to a complete economic decline that takes place over a long period of time, typically six months or longer. In a recession, stock values plummet, as they did during the Great Recession, when they fell 55%.
- Market bottom: The market bottom is the lowest price a security trades over a specific interval. It could also influence the entire market based on a benchmark index. The interval could be any length of time but most refer to a year or more. If you take a look at a line graph showing a security’s price over time, the bottom would be the lowest point on the line, also called the trough.
What influences downtrends? News catalysts, government, international transactions, speculation and expectation and supply and demand all influence downtrends. In fact, a mix of factors causes both short- and long-term changes in the market.
How to Identify Downtrends
What are the best ways to identify downtrends? They are characterized by several influencing factors and you can identify them in several ways. Peaks and troughs identify downtrends (and uptrends, for that matter). An uptrend creates increasingly higher price peaks and troughs while a downtrend creates ever lower price peaks and troughs. During a downtrend, the lows tend to be lower.
Consider using line graphs, moving averages, trend lines and the Average Directional Index (ADX) to identify downtrends. Let's take a look at each.
- Line graph: You can take a look at a stock chart in line graph format and quickly grasp the downtrend over a period of time. From a distance, you may be able to see a mess of movement both up and down. Downtrends show peaks and troughs that generally go down.
- Moving averages: What is the moving average? A moving average is a statistic that captures the average change in a data series over time which you can use to identify trends.
- Trend Lines: You should be able to draw a trend line or resistance line by connecting two or more peaks (the high points) or under the pivot low points to give you a great visual indicator of support and resistance as well as price changes.
- Average Directional Index (ADX): The ADX contains three different lines: The ADX, which can alert you to the strength of a trend as well as two directional indicator lines: +DI and -DI. A -DI line indicates bearish strength, and those below 25 can indicate a downward trend.
Are Downtrending Stocks a Good Investment?
It depends, of course, on a few factors. As a trader, downtrending stocks can offer major trading opportunities. In fact, in many cases, stocks fall faster than they grow, so trading in a downward direction can allow traders to take advantage of heftier price action that way. However, it also comes with certain risks, which we'll detail below.
Top Downtrending Stocks
Let's take a look at a few downtrending stocks you may want to consider trading as of this writing.
Cano Health Inc.
Cano Health Inc. (NYSE: CANO), headquartered in Miami, offers primary care medical services to members in the U.S. and Puerto Rico. The CanoPanorama health management and technology-powered platform provides health care to improve care decisions and member engagement. It also operates pharmacies and dental services and approximately 1,000 affiliate providers.
KnowBe4 Inc.
KnowBe4 Inc. (NASDAQ: KNBE), headquartered in Clearwater, Florida, develops, markets and sells a Software-as-a-Service-based security awareness platform which incorporates security awareness training to help organizations manage social engineering. Its products include security awareness training, compliance training and more. Its products include Security Coach and PasswordIQ.
Cassava Sciences Inc.
Cassava Sciences Inc. (NASDAQ: SAVA), based in Austin, Texas, is a clinical stage biotechnology company which develops drugs for neurodegenerative diseases. Its two lead drugs are Simufilam and SavaDx, a diagnostic drug that detects Alzheimer's disease.
How to Trade Downtrending Stocks
Next, we'll examine how to trade downtrending stocks, starting with identifying the method you want to use to trade.
Step 1: Identify the method you want to use to trade or invest.
There are a few ways to trade downtrending stocks, including short selling, short selling with derivatives and more. There are also a few ways to hedge against downturns included in this list as well. Let's take a look:
- Short selling: Short selling is one of the most popular ways to profit off of market declines. Traditional short selling means that you borrow the share from your broker and sell it at the current market price. You then buy the shares back at a lower price at a date in the future. At that point, you return the shares to the lender and can put the difference in price in the bank. However, if you bet wrong and the market goes up, you have to buy the shares back at a higher market price. Unfortunately, if it goes in this direction, you could experience infinite losses because the market can rise infinitely.
- Shorting exchange-traded funds (ETFs): You can make money by shorting ETFs when the underlying benchmark declines. Inverse ETFs also allow you to profit in a downward market without having to short anything at all.
- Invest in safe-haven assets: Safe-haven assets allow you to hold onto something that retains its value even when the broader market declines (think gold). It's an alternative to closing positions or going short.
- Forex trading: You can also use the forex market as a hedge against downtrends. In forex trading, a trader buys a currency and sells another in order to make money between the two.
- Options trading: Options trading allows you to work within a contract that allows you the option, but not the obligation, to buy or sell an underlying asset at a specific price by a set expiration date. It's a great way to hedge against falling share prices. A put option gives you the right (but not the obligation) to sell a stock at a certain price by the expiration date. You can also write covered calls. This means you sell a call option against a stock you own. You accept the obligation to sell that stock to the holder of a call option. If the buyer chooses to exercise the option, you must sell your stock, which does limit your profit. As a market begins to go into freefall, taking this route can be a great way to earn some cash. However, it's worth noting that trading options is risky, particularly because you're trying to predict what the market will do. This can result in large losses. Options prices can fluctuate wildly.
No one method is better than another, but you must choose an option with which you feel comfortable.
Step 2: Open a trading account.
If you don't already have a trading account handy, choose the correct trading account and fund it. Don't forget to consider the fees involved, the platform bells and whistles and other factors that will help you become a successful trader.
Step 3: Start trading.
Once you've set up your trading account, consider using paper trading before you start using real money. Paper trading lets you practice using a completely fake account with fake money. If you've never traded before, you may want to spend a chunk of time learning how to trade on a paper trading account before you officially get started.
Once you're ready to trade, get started, but don't trade more money than you're willing to lose. You can incur serious losses.
Final Thoughts
When you were a novice investor, you may have thought it was a "bad thing" when the stock market fell. However, that's just not true. Any savvy investor or trader will know that they can trade falling prices and make money in the process. A downtrend could offer a buying opportunity — it's like buying stocks at an incredible bargain.
For traders, the dollar signs might loom even larger when the markets are in freefall. Take as many opportunities as possible to figure out which stocks will benefit you based on your investing and trading method. You may have to play around with several types of trading methods before you land on the right one for you.
Finally, carefully consider the risks involved in trading and how important it is to bring a practiced hand to the table. It's worth mentioning again: It's a good idea to consider paper trading before you ever use real money. Paper trading allows you to use a simulated account to trade "fake" money. It allows you to get comfortable with the process before you commit to possible losses.
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