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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 financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including thousands of original and objective articles and tutorials on a wide variety of financial topics.