The Downtrend
A downtrend occurs when stock prices trace lower highs and lower lows. We can sometimes add a falling trendline to a chart by linking the high points. This is shown in the chart below.
As soon as we have two consecutive highs we can join them to make an unconfirmed falling trendline.
For the trendline to be confirmed, and hence validated, the price chart must respect it by rebounding from it a third time.
Confirmation of a falling trendline is a powerful sell signal.
Chart of a Stock in a Downtrend
After confirming a falling trendline, we stay out of the stock for as long as the share price stays below the trendline.
Many investors are attracted to stocks whose price is falling. These investors are in search of a bargain - a natural human instinct.
O'Shaughnessy* found, however, that a strategy of investing in stocks whose price had fallen significantly resulted in poor returns compared with other strategies.
It is preferable not to buy a stock whose price is in a downtrend. Wait for an indication the downtrend is over.
For some, the end of the downtrend might be signaled by a trendline break, shown in the chart on the right.
Others prefer to buy only after an uptrend has been confirmed. In the charts shown on this page, although an uptrend follows the downtrend, the uptrend is not confirmed. You can see a confirmed uptrend here.
*What Works on Wall Street by James P. O'Shaughnessy. O'Shaughnessy was the first outsider to be granted access to the S&P Compustat Database. The database contains comprehensive fundamental and technical data reaching back as far as the 1950's. O'Shaughnessy used Compustat data to backtest various investment strategies and one of his discoveries was that investing in stocks whose price had fallen substantially was unlikely to yield a good return in the following 12 months.