In a financial market cycle, there are four major phases:
- Accumulation phase, where the price of a cryptocurrency tries to bottom after a prolonged downtrend and enters a base-building process. In this stage, new investors replace the old ones, which in return replaces fear and depression with hope and optimism. Price action generally moves within a horizontal range during the accumulation phase, which is a great opportunity for profit for short-term traders to buy at levels of support and sell at resistance.
- Uptrend is when market participants buy aggressively once the price of the asset leaves the accumulation zone to the upside. In the early stages of an uptrend, there are usually a small group of investors buying a certain asset, who is then joined by a much larger group of weak-handed retail participants in the later stages. The early stage of an uptrend is smooth and linear and price increases with consistent higher highs and higher lows but the price action gets ferocious in the late stages with many bull traps and swing failures.
- Market top, where an uptrend is faced with strong resistance, and the price starts to make lower highs instead of higher highs, as time passes. Strong hands that joined the market in the early stages of an uptrend take profits in this phase, as a result, buying volume starts to decline significantly.
- Downtrend occurs when there are more sellers than buyers. This drops the price of the cryptocurrency to decreased levels that are unanticipated by long-term holders. A downtrend may take much longer than expected. A downtrend begins with high price volatility but ends with low volatility because apathy and disinterest dominate the late stages of a downtrend.
How To Identify a Downtrend
A downtrend, or alternatively called a bear market, starts after a market top is reached at the end of an uptrend. It is difficult to identify the start of a downtrend because you cannot know for sure whether the falling prices are just a correction within the uptrend, or that a bear market started.
One way to understand whether a cryptocurrency is in a downtrend or a correction is to look at the volume profile. If prices are falling on a higher volume than the volume that ascended them to the same levels, it is more likely that the cryptocurrency is in a downtrend.
A more valid indicator is to identify whether the price makes a higher high or a lower high when it bounces, compared to the high price of the previous uptrend. If recovery after a crash falls shorter than the uptrend’s top, it may suggest that the asset is experiencing a downtrend.
Stages in a Downtrend
- Panic and fear
- Relief and hope
- Capitulation and depression
Panic and Fear
A downtrend usually starts at the end of euphoria in the market, which is a consequence of accelerating price hikes at the end of an uptrend.
During the cooling period when the market tries to evaluate whether it is experiencing a correction or a downtrend, denial typically overrules the market because the majority of investors are still quite optimistic and convinced that they are merely experiencing a correction and that there will be another leg to the upside. But when prices continue to fall in full swing, panic and fear start to dominate as losses become bigger and bigger.
Relief and Hope
A significant bounce rally most often follows panic and fear in the markets since nothing goes straight up or straight down. This gives hope to the market that prices will climb back to their previous highs.
However, in an extended downtrend, such rallies end up as being no more than a relief period, because many investors sell their positions after recovering some or all of their losses without enough buyers buying into those positions. Due to this, the rally fails at some point and prices retrace to their lows during the panic and fear stage.
A typical characteristic of relief rallies is that prices make a lower high compared to their bull market highs. The market runs out of new buyers at some point and prices start to fall back.
Capitulation and Depression
Failed rallies during the relief and hope stage pave the way for the capitulation and depression stage. Capitulation is the stage of selling cryptocurrencies at a significant loss because investors lose hope that prices will ever increase and that they will just keep falling. Since cryptocurrencies are a very volatile and speculative asset class, capitulation is much more likely to happen with them during the late stage of their downtrends.
Cryptocurrency prices typically fall the largest and quickest during the capitulation phase. It is even possible for Bitcoin, the largest and most established cryptocurrency, to experience a drop of up to 50% in a single trading day.
As an example, following the 2017 bull market high of $20,000 per bitcoin, the alpha cryptocurrency had its first downtrend (the panic and fear stage) when it crashed from $20,000 in December 2017 to $6.000 by February 2018. Following that, Bitcoin had several relief rallies throughout 2018 but every time the price failed to exceed $10,000 and retraced to $6,000. This stage was followed by a capitulation period, where the price of Bitcoin fell from $6,000 to $3,000 in December 2018 in only two weeks.
An even more drastic capitulation for Bitcoin was the COVID crash in March 2020. Bitcoin completed its second downtrend in the 2018/19 bear market (which started when Bitcoin topped at $14,000 in June 2019) by capitulating to $3,800 from $8,000 in less than 24 hours.
When markets capitulate, there is usually a period of depression as the remainder of investors have finally surrendered to the ever-falling prices and have exited their investments with huge losses. During this period, prices generally remain dead flat as there are no more sellers left and there are not many buyers who have the confidence to step in and buy at those highly depressed prices. In that sense, this flat-price period can be regarded as the depression period which constitutes the end of a downtrend.
Identifying Stages With Elliott Waves
To accurately identify each stage in a downtrend, there is a need for an objective methodology because the above-discussed stages relate to the psychology of a market, which is subjective. Everybody has a different perception of extreme fear, hope, and depression.
The most common objective way to identify the stages of a downtrend is using the Elliott waves. The Elliott Wave Theory is the benchmark technical analysis tool used by financial traders to identify market cycles and forecast different market trends. According to the Elliott wave theory, every downtrend consists of three major stages with two waves to the downside and one way to the upside. Prices drop during waves A and C and they bounce during wave B.
The Elliott Wave Theory suggests that there is usually alternation in the duration of waves A and C. This means that if wave A happens very fast with huge crashes, wave C generally lasts longer with more gradual price decreases and a lot of sideways movements.
Bitcoin followed a perfect A-B-C correction sequence during its 2018-19 bear market as you can observe in the below chart.
Wave A was very quick and violent, where the price of Bitcoin crashed from $20,000 to $6,000 in only one month. Such a sudden and drastic crash was followed by an almost equally strong bounce in wave B, where the price jumped from $6,000 to $12,000. Finally, in accordance with the alternation rule in the Elliott wave theory, wave C took quite a long time with seven months of sideways price action and ended with a capitulation in December 2018 at $3,000 per coin.
During wave A, there is higher selling volume compared to the buying volumes in the late stage of the bull market. The intensity of the sell volume during wave A determines its length and duration.
Increasing sell volume is a response to deteriorating fundamentals for the specific cryptocurrency. During wave A, negative news and developments start to come out for the asset but the continued optimism of the overall market causes the majority of investors to ignore these developments.
Wave A typically ends when those reckless investors start to feel intense panic and fear due to an acceleration in the dropping of prices.
Wave B constitutes the relief rally during a downtrend. Prices rise without any improvements in the fundamentals of the asset even though fundamentals have not turned entirely negative either.
Although Wave B usually ends with a lower price compared to the bull market top, depending on the strength of the bounce (and thus market interest), the price may reach as high as the bull market top or even exceed it. But in contrast to what the majority of market participants might think at that point, this would not mean the start of a new uptrend.
If the price tops just a little above the previous bull market top, this would instead constitute a “bull trap”. You can identify a bull trap if prices climb with lower volume compared to that of the previous uptrend. In that sense, the volume during wave B should be lower than the volume in wave A.
Bitcoin’s surge from $29,000 in July 2021 to $69,000 in November 2021 is a perfect example of a wave B that ended with a bull trap. During wave A of the downtrend that started in April 2021, Bitcoin fell from $65,000 to $29,000. Wave B started following that, which did not only rise as high as April’s bull market highs but even surpassed it to $69,000.
Wave C starts when the relief rally runs out of steam. There are no positive developments in the fundamentals of the market, and as a result, investors run out of incentives to buy more.
There is usually alternation between wave A and wave C in the way that prices fall. For example, if the fall was very rapid and violent during wave A, then wave C may have a more gradual downtrend. However, selling volume picks up significantly in wave C, and panic and fear strike again as investors lose their entire gains from wave B. At that point, almost everyone realizes that a bear market is firmly entrenched.
The length of wave C depends on the strength of the overall downtrend. Usually, the price makes a new low compared to the low price in wave A. A lower wave C is very common in cryptocurrencies since they are a very speculative asset, as a result, they can be sold down to extremely low prices during the capitulation and depression phase of wave C.
Some Closing Thoughts
A downtrend generally consists of three psychological stages – panic and fear, relief and hope, and capitulation and depression. These stages can be laid out using the Elliott waves. The length and duration of each corrective move depend on the power of the overall downtrend, which is determined by the level of panic and fear in the market.
A very critical thing to note is that you should never try to catch the bottom in a downtrend. Regardless of how experienced you are with the psychological or technical stages of a downtrend, bear markets may last much longer than you think and prices may drop to extremely depressed levels than what your analysis may suggest.
Depending on what type of trader you are, be it short-term or long-term, you can adapt the different stages of a downtrend to your timeframe of interest – could be monthly, weekly, daily, or even hourly (if you are a day trader).
Disclaimer: For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.