Peak-and-Trough Analysis

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.

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.

Chart Created with Tradestation

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 Dec 2001 to the third week of Apr 2002 the stock price moved from about $46.50 to the $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 of 2001 to the close Jun 27, 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 Dec 7, 2001, to $1.50.

Chart Created with Tradestation

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.

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.

Finally, 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.