Today's Trading Lesson From TradingMarkets

In keeping with the Point and Figure tradition of simplicity, this lesson will go through four effective patterns used to interpret this charting system. In my previous lesson on Point and Figure, I gave the basics for creating these charts. Identifying patterns in this system is conceptually the same as with bar charts. When demand reaches a clear position of authority over supply, a buy signal is triggered. The reverse is true when supply takes control. The beauty of Point and Figure charting is its apparent precision. I use the technique for position trading in conjunction with candlestick and volume indicators. When referring to the "P and F" charts, I know I’m looking at a logical record of buying and selling pressure. The relevance of linear time may not be evident, but what I do see is where the money is.

Point and Figure patterns are nearly identical to those of bar charts. Double and Triple Tops and Bottoms, Head and Shoulders, and Cup and Handles are the more common patterns the two charting systems share. Despite this, there are fundamental differences behind their construction. Bar charts record both price and time, while Point and Figure charts only represent price movement. The bar chart system moves forward by depicting time on variables anywhere from typically one minute to a yearly basis. The Point and Figure method shifts when there is a clear change of control between buyers and sellers. Because the Point and Figure method filters time, the patterns it produces can be interpreted as a very clear and simple representation of change. The ability to alter Point and Figure box size and reversal numbers gives the method flexibility to adapt to the time frames of any trader. Regardless of the settings used, the patterns are still the same.

For my trading purposes, I stick with the traditional Point and Figure method by keeping with the standard box sizes and reversal number of three. My outlook is usually for the intermediate-term. Setting smaller variables will make the charts more sensitive and ideal for shorter time periods. An increase in the box size will require a larger increase in price to produce a breakout, therefore making it more suitable for longer-term trading. The patterns I will discuss for this lesson are the Double Top and Bottom, and the Triple Top and Bottom. 

Anyone familiar with these patterns on bar charts will see there is really no gray area involved when applying them to Point and Figure. The majority of the patterns occur at a fulcrum of price-action. This fulcrum is a congestion area that is usually created after a significant advance or decline. These basing areas are the breeding ground for the patterns used to identify breakouts and breakdowns. Typically the wider the base, the bigger the move out of it. In Point and Figure terms, this means the more columns involved, the greater the likelihood of a column extending into bull or bear territory.

Below are examples of the most common Point and Figure patterns:

Double Top: In this example with Myriad Genetics (MYGN), you can see the fulcrum that exists before its big move up. The double top is defined when the price action reaches a point, then returns after a decline to test it. Once this area of resistance is broken, a buy signal is created. Conceptually, this means that buying pressure has exceeded selling pressure. This is the most common of all Point and Figure Patterns.

Triple Top: In this example with Earthlink (ELNK), a triple top was formed at the fulcrum and the buy signal marked the start of a small gain before a pullback. In general, when there is a breakout from a triple top, there is a larger move upward than from a double top. In other words, when the buying pressure finally wins out over the selling pressure, it breaks out. The wider the base, the larger the gain.

Double Bottom: In this example with DoubleClick (DCLK), a double bottom and a breakout marked the fall of the stock for four boxes. Buying pressure subsided to the selling pressure and the stock broke down. Notice how the first bottom also served as a sell signal for a previous double bottom that didn't materialize. Also notice there wasn't much of a base formed either.

Triple Bottom: This example with Capital One Finance (COF) shows a triple bottom that broke down out of its base with a sell signal that marked a 5-point move. After three columns of exchanges between bulls and bears, the bears won out. Notice the support marked by the bearish column eight columns over from the breakdown signal. The case can be made that when this price level was broken, a further decline was imminent. These patterns always work best when used with other forms of technical analysis.

All the patterns discussed in this lesson share two common properties. A fulcrum is formed, and a fulcrum is broken. In this same respect, quadruple tops and bottoms can be formed that typically have greater upward potential because of their wider bases. I like to think of this as a common sense approach to analyzing the relationship between supply and demand. Other patterns, such as triangles, are also effective for interpreting these charts, but that is for another lesson.

Point and Figure charting has been around for over a century and is still used today -- because it works. I've never heard of anyone who makes all of his or her decisions from these charts, but what they're good for is clarity. Identifying support and resistance with these charts is a no-brainer, and in this business, keeping things simple can allow a trader to stay focused and on the right track to success.