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
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