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Peak-and-Trough Analysis

2011-07-29 17:56:13

Peaks and troughs are patterns that are developed by the price action

experienced by all securities. As we know, prices never move in straight lines,

whether in an uptrend or a downtrend. The term "zigzag pattern" has been used

to describe the peaks and troughs, and many charting software programs will

have a '%-zigzag' indicator that investors can lay down on a chart that they

are viewing.

The Ups and Downs

Rising peaks and troughs can be seen easily on a chart by recognizing the

higher peaks, or tops, and higher troughs, or bottoms, creating the uptrend.

Another way to look at it would be to recognize that each new top that is

created by the price action is higher than the high of the previous few days,

weeks or even months of trading. As well, each new trough would also be higher

than the previous trough over the same period of time. (This technical

indicator is underused in the currency markets, but it can help you isolate

profitable opportunities. Learn how to Make Sharp Trades Using Andrew's

Pitchfork.)

In the above chart of PepsiCo Inc. (PEP), up arrows show you the rising troughs

and down arrows indicator the rising peaks of this uptrend. From the middle of

December, 2001 to the third week of April, 2002, the stock price moved from

about $46.50-53.50 range, a percentage move in the area of 15%, exclusive of

commissions.

In the second chart, you can see the downtrend of Nortel Networks Corp. (NT)

from December, 2001 to the end of June, 2002, and the arrows show the falling

peaks and troughs each breaking new ground from the previous price action

pattern. In this chart, the stock price declined from $9.25 on December 7,

2001, to $1.50. (Understanding the business cycle and your own investment style

can help you cope with an economic decline. Learn more in Recession: What Does

It Mean To Investors?)

Trend Breaking

The easiest way to determine whether or not a trendline has been broken is to

witness the breakdown and then replacement of either rising or falling peaks

and troughs. Given that chartists place a great deal of emphasis on the

psychological aspects of technical analysis, some technicians might agree that

this tried and proven technical indicator outshines most, if not all,

trend-following techniques. Investor confidence and an optimistic view of the

future of a particular issue drives stock prices upward, and conversely, lack

of confidence (seen in the Enron, Anderson, WorldCom and Martha Stewart issues)

see even the most stalwart issues begin a downtrend.

The Rule of Thumb

We should be aware of consolidation in the study of peaks and troughs to

recognize this sideways pattern, avoiding the mistake of thinking that the

prevailing trend is about to reverse. The rule of thumb is that consolidation

will generally take 33-66% of the time it took to play out the time frame of

the previous trend. But don't let this rule replace investor common sense and

experience that comes with investing over a long period of time.

At the same time, peak-and-trough analysis is a solid no-nonsense approach to

trend analysis and should not be forgotten in days of a search for the bottom

of the market and the subsequent turnaround. When times are tough, investors

should take a hard look at peak-and-trough analysis of their own issues, and

coupled with a moving-average indicator, begin the search for what could be a

dramatic turnaround for some of their beaten up issues. But be careful in that

you do not make the mistake of using a time frame that is too short. Peaks and

troughs are developed over weeks and months of price action, not hours and days

of trading.

Conclusion

Remember that price action is made up of rallies and subsequent reactions.

Also, recognize the time frame of the rising peaks and troughs (or, falling

peaks and troughs) to determine the strength of the trend, and remember that

overall market confidence or lack thereof will reverse a trend faster than any

indicator developed as technical analysts. (Companies with falling revenues can

be profitable, but choose them with care. Read more in Battered Stocks That

Bounce Back.)

It's your money invest it wisely. Learn, understand and execute.

by Investopedia Staff

Investopedia.com believes that individuals can excel at managing their

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