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.

Key Takeaways

• Peaks and troughs are patterns that are developed by the price action experienced by all securities.
• ​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.
• ​We should be aware of consolidation in the study of peaks and troughs to recognize this sideways pattern, avoiding the mistake of thinking the prevailing trend is about to reverse.

The Ups and Downs of Peaks and Troughs

​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 peak 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.

In the above chart of PepsiCo, Inc. (PEP), up arrows show you the rising troughs and down arrows indicate 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 to $53.50, a percentage move in the area of 15%, exclusive of commissions.

Breaking Trend

​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 sees 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 the prevailing trend is about to reverse. The rule of thumb is that consolidation will generally take 33-66% of 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 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 that the time frame of the rising peaks and troughs (or falling peaks and troughs) determines the strength of the trend and that overall market confidence or lack thereof will reverse a trend faster than any indicator developed by technical analysts.

Read the original article on Investopedia.