Traders Toolbox: Reactions within a downtrend

Many traders, especially those who have not traded very long, find trending declines very difficult to trade. Many trading and analytical tools which perform well in uptrends, or even in sideways patterns, often perform differently in downtrends. This is not to say such tools will not work well in a downtrend, but, realistically, many perform differently.

Many traders (once again, especially those with little experience) tend to be biased to the long, or buy, side of the market. Such traders often have difficulty adapting to the changes which may occur in the performance of their favorite tools in declining markets. Thus, many tend to shy away from the short side of markets. This is unfortunate as markets often fall more quickly than they go up. As a result, profits can be potentially harvested faster in a down move than in an uptrend.

While some traders tend to avoid the short side of markets altogether, others would be interested in selling short if only they could find a way to get on board trending declines. As mentioned earlier, while many tools don't appear to work as well in a down- trend, there is a pattern which occurs often enough to be helpful in analyzing and trading.

The reliable pattern which often develops within down trending moves is a consistency of the upward reactions. The consistency within upward reactions can be in terms of time or price or both. However, most patterns tend to involve time, either alone or in combination with price.

Generally speaking, upward reactions in true downtrends tend to last from 1 to 3 days. The reactions are not limited to 3 days; however, many declines will follow this pattern.

To be more specific, individual markets often mark the maximum time span of most upward reactions with the first rebound in a downtrending pattern. For example, if the first upward reaction lasts two days, many of the subsequent rebounds within the downtrend will last two days or less. A good example of this phenomenon occurred in the February/March, 1991 collapse in the currency markets.

The first rebound in the Swiss franc, following the posting of the February high, lasted for about a day and a half. From that point forward until the primary downtrend came to an end in late March, no upward reaction (arrows) lasted much more than a day and a half. And, when the Swiss franc rebounded for more than a day and a half, (circle) it proved to be a signal the clean portion of the downtrend had come to an end.

The trading strategy is quite simple. In general, traders may look to sell 1- to 3-day rebounds in downtrending markets. If a reaction lasts longer than the longest previous reaction, the strategy then moves to either being stopped out or to look for a gracious way to move to the sidelines on the next break. This is done because, even if the market eventually moves lower, what remain, compared to the previous trending portion or "meat" of the move, often prove to be the "crumbs." Obviously, the strategy is adjusted when a specific market has marked its reaction time.

The spring, 1991 situation in the new-crop corn market pres- ents an example of a time span longer than three days being marked as the primary reaction time. After collapsing from the March high, December corn marked its key reaction time with the sharp rebound into early April. This 4-day bounce set the stage for subsequent reactions to last from 1 day to 4 days. In addition, December corn has marked the likely size, in terms of price, of most subsequent reactions.

The rebound posted in December corn into early April was 13.25(E. This is likely to be the approximate size of the largest subsequent rebound which occurs within the downtrending move. A rebound which is substantially larger than 13.25 cents is likely to signal an end of the primary decline. However, on a daily degree, it is rather obvious that a 13.25C rebound in corn is a large reaction. While a 4-day reaction time is realistic, most reactions in price are likely to be smaller than 13.25 cents.

Notice the 4-day rebound which followed the posting of the April high. This upward reaction was 5cents. From this point on, it was/is reasonable to expect most reactions to be in the neighborhood of 5(t or Go; and to last from 1 to 4 days. However, it would be wise to allow for at least one larger-degree rebound of about 13 cents.

In the spring, 1991 situation in the December corn market, a possible trading approach would be to sell rebounds from a new low of 5cents to 6cents. Risk could be limited to a point which is 14cents or 15cents above a new low. Thus, the effective risk should be about 8cents to l0cents. Once a new low is posted, if one were using "tight" stops, the risk could be limited to about 7cents to 8cents above each new low. Otherwise, a 14cent or 15cent trailing stop above each new low should keep one in position for the bulk of a move. While this is a possible approach, it is not necessarily a specific or the only approach to trading a short position.

As always, knowing the personality of a market can prove beneficial. In the spring, 1991 corn market, it was wise to allow for one rebound in time of up to ten days. This is due to the presence of such rebounds in time in potentially similar previous downtrends in the corn market.

The tendency for consistent reactions in a downtrend should be an attractive addition to one's technical "toolbox". This pattern offers a low-risk method to reap potentially substantial rewards.

10 thoughts on “Traders Toolbox: Reactions within a downtrend

  1. A very nice article, and hopefully, a good addition to my toolbox. 🙂
    I have 2 queries:
    1) Can the same logic be used for reactions in an UPtrend?
    2) Is it possible for you to post the marked "Corn charts" somewhere and send us the link to it?

    Thanks again for the superb article.


  2. Apart from the problem of the missing chart, (which has still not been rectified) the Swiss Franc chart could have done with more complete labelling - I assume the bars are day? Letters or numbers to indicate the rebounds would assist the reader. Also, surely you could have found more recent charts to use rather than 1991? I am consistently exasperated by commentators who use charts from more than a decade ago. Use more recent ones. There are plenty of examples.

  3. Hi Marilyn, You are correct in your assessment of IRA's and shorting. HOWEVER, you must step out of your comfort zone and study option strategies. You may short most markets using this additional Tool in your Toolbox, even in your IRA. Your brokerage account must be reviewed with additional paperwork, so that you can participate. Don't go there without study. There are strategies that employ methods of reducing your risk, and participating in the move down. HAPPY TRADING!

  4. Very good introspection is needed in good trading. By my experience, as a potential solution for considered problem, good method is to draw trend line, wait for breakout of that trend line, and consider entering to trade somewhere at testing the breakout of trend line or somewhere at low of price before the breakout. Of course, must have is to set the appropriate stops. Other methods of confirmations are welcome.

  5. Hi. Your site appears to be one of the genuine helpful findings, as opposed to most which just want to sell questionable "research" material. I've had my fill of sites that make the viewer sit through a slowly read, uninterruptable, un-pausable background buildup for a dubious product they are hawking.

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    Bernie Katz

  6. Very good article. I will be watching to see how well this works. It would have been helpful to have the corn chart, tho. It looks like there was a space to the right of the currency chart for it. I can see how this strategy could help with shorts, but I can't use shorts in my IRA. It also looks helpful in determining how long a put strategy is apt to hold, and to keep from closing out too early! Thanks again for pointing out a pattern I had not seen before.

  7. If you are a wave counter the large reaction was a ABC Wave 4 Up in a douwntrend and it continued on down to a wave 5 bottom. I predict that it has now put in a wave 1-2 and will continue up. But I have been wrong before!

  8. Hi Jennifer,

    This is an informative and useful article. I'm wondering if you intended to include a chart for December corn; you use the phrase "...notice the four day rebound..." which leads me to believe that a chart should have been illustrated. Certainly, the example would be more clear if a chart was shown. Can that be added?



  9. " Notice the 4-day rebound which followed the posting of the April high "
    The corn example chart is missing

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