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.

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.

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.

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.

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.

Even in a flat market these emotions can be prevalent. Traders may practice buying at the lower edge of a range and shorting at the upper edge. In uptrends, bears who engage in short selling will naturally feel pain, and bulls will experience regret that they did not buy more. Both will be eager to buy if and when the market gives them a second chance, which will create support during investors' reactions in an uptrend.

Resistance indicates bulls feeling pain, bears feeling regret, and both camps ready and waiting to sell. A downward breakout from a trading range will cause pain to bulls who bought and will make them eager to sell during the first market rally so that they can get out even. Bears will regret not shorting more and wait for that same rally to allow for a second chance to sell short. The pain of bulls and the regret of bears in a downtrend translates into what is referred to as resistance.