How to identify and trade a downtrend February 24, 2023

How to identify and trade a downtrend

Introduction

When the stock markets take a dip, investors tend to panic sell. However, there are ways and opportunities for you to take advantage of the falling prices, even during a downturn. When trading stocks, you can profit from both an uptrend and a downtrend. Comparing the two, downtrends tend to move faster than uptrends, resulting in many opting to only short sell stocks in order to capitalise on the quick price action.


What is a downtrend?

A downtrend is a gradual reduction in the price or value of a stock or commodity, or the activity of a financial market. It is most recognisable by prices creating lower lows and lower highs that can occur over any timeframe.

How to identify and trade a downtrend



How to trade a downtrend

During a downtrend, it is common to see traders sell off stocks to take profit as many others panic sell from fear of stock prices dipping even further. On the flip side, some may see this as an opportunity to buy more shares, with the attractive valuation and discounts on these stocks.


So what should you do when there is a downtrend?

Firstly, identify the trend and observe using the time frame you are trading in.

Secondly, identify the position you currently have. If you are holding a position and are in profit, you might want to consider taking profit if there are no signs of reversal in sight


Here are some options that traders should consider when trading a downtrend.

Inverse ETF: What is an inverse ETF?

An inverse Exchange-Traded Fund (ETF) is an investment vehicle constructed by using various derivatives to profit from a decline in the value of an underlying benchmark. The construction of an inverse ETF involves borrowing of securities and selling them with the hope of repurchasing them at a lower price.

If you wish to know more about inverse ETFs, check out these two articles, which explain how to short the market using ETFs, leveraged as well as inverse ETFs.

https://www.poems.com.sg/market-journal/how-to-short-the-market-using-etfs/
https://www.poems.com.sg/market-journal/leveraged-and-inverse-etfs-101-2/

Short a position using Contract For Differences (CFD)

What is shorting a position or short selling? Short selling is a trading strategy that traders use to take advantage of falling markets. When you short sell, you sell a borrowed asset with the hopes that its price will go down so that you can buy it back later for a profit.

Example: Short-selling in CFD trading

Jasvind currently has a bearish view on stock A. As he is not allowed to use normal stocks on the cash market to short-sell stock A, he decides to use CFDs to do so instead. Stock A is currently trading at a price of S$3.00. Jasvind sells 5,000 contracts at the bid price of S$3.00.

A week later, the price of stock A drops to S$2.50 and Jasvind decides to close his contracts. He buys 5,000 contracts of stock A at the ask price of S$2.50. The total profit Jasvind made from this trade: (S$3.00 – S$2.50) * 5,000 = S$2,500.

However, if the price of stock A goes up a week later to S$3.50 and Jasvind decides to close his contracts by buying 5,000 contracts of stock A at the ask price of S$3.50, he would have made a loss of: (S$3.00- S$3.50) * 5,000 = S$2,500.

Short selling explained:

Watch it here.

Some assets that are readily available to trade long and short with CFDs:

  • Stocks/Equities CFD
  • World Indices CFD
  • Commodities CFD
  • FX CFD

DLC short

What are Daily Leverage Certificates, or DLCs?

DLCs are a form of structured financial instruments issued by the banks for trading on the securities market. They offer investors a fixed leverage of 3 to 7 times the daily performance of the underlying index, regardless of a rising or falling market. The basic principle is simple – if the underlying moves by 1% from its closing price of the previous trading day, the value of the 3x DLC will move by 3%.


How do DLCs work?

1. Daily Long and Short

DLCs are designed to be traded over short periods of time, predominantly on an intra-day basis. They offer the flexibility to trade both in the rising and falling markets. For each underlying and leverage level, there is a long and short DLC available. A bullish investor who thinks that the underlying index is set to rise over the trading day can select, for example, a 3x Long DLC, which will rise in value by 3% for each 1% rise in the underlying index (before cost & fees). A bearish investor who expects the underlying index to fall can instead select, for example, the 3x Short DLC, which will rise in value by 3% for every 1% fall in the underlying index (before cost & fees).

2. Compounding effect

If an investor’s trading horizon is over the span of a few days, it is important to note that the performance of the DLC may vary from the leverage factor of the DLC in question. Why? The performance of the underlying index and the DLC is reset at the end of each trading day. When markets open the next day, the performance of the underlying index and DLC will be measured from the closing levels recorded on the previous trading day. This means that any subsequent performance of the DLC is calculated based on the performance achieved the day before. The same process is repeated on each trading day, where profits or losses will be compounded.

3. Airbag mechanism

An airbag mechanism is built into the DLC to slow down the rate of loss in the value of the DLC in extreme market conditions. Each DLC listed will have a pre-set trigger for the airbag mechanism. This trigger is usually activated upon a 10% movement in the underlying index for a 5x DLC and a 20% movement for a 3x DLC (based on the closing price of the underlying index on the previous trading day). The airbag mechanism will only be triggered upon movements of the underlying index that goes against the direction of the product.

For example, if the underlying index falls by 20%, the airbag mechanism

(A) for a 3x Long DLC will be triggered, as the value of the DLC falls alongside the underlying index

(B) for a 3x Short DLC will not be triggered, as the fall in the underlying index would result in an increase in value of the DLC by 60% (3 x 20%).


The current state of the market

Inflation rates remain high, partly due to higher energy costs triggered by the Russian-Ukraine war. They are also the result of cost pressures generated by pent-up demand as economies reopen after lockdowns, where firms are unable to keep up with demand.

Although it might be is too early to predict if a recession will occur in the US in 2023, the probability of such a downturn increases as the inverted yield curve becomes more pronounced. The indicators that the Federal Reserve is focused on, such as payrolls and wages, remain overheated; although this labor-market trend tends to lag other indicators. This creates the risk that Fed Chair Jerome Powell might will continue to tighten monetary policies even as economic conditions deteriorate. This may imply that it is unlikely for Powell to navigate a pivot towards a less hawkish monetary policy in early 2023.

The Eurozone and United Kingdom are facing prospects of a recession, with the surge in as surging prices for natural gas hitting hard. China’s economy remains weak, although it might be worthy to note that there is stimulus happening, albeit gradually. The end of China’s COVID-19 lockdowns—hopefully by early next year—should allow recovery.


Reference:

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About the author

Liew Zhen Shen Johnson
Equities Specialist

Johnson holds a bachelor's degree of Science in Business Administration and a bachelor's degree of Arts in Economics. He employs fundamental and technical analyses with experience in a multitude of financial instruments. He joined Phillip Securities in 2020 as an Equity Dealer. Apart from providing dealing services, he also conducts training seminars to further introduce financial knowledge to the public.