Do you want clear buy and sell signals from your charts? Here’s how…
Editor’s Note: Sara Conway is the latest contributor to
join us here at TradingMarkets.com. Sara’s primary analysis technique is point
and figure charting, which may be unfamiliar to some readers, so Sara’s first
article is an introduction to p&f. If you have any questions please contact Sara
or the Editorial team and we will do our best to answer them.
Point and Figure Charting Simplified
Point and figure is one of the oldest forms of charting. I
find that it is a great tool for the intermediate-term trader, and, it is my primary
tool for making analytical decisions about the market. Stymied by the Xs and Os?
Don’t be. It is a very logical system using simple top down analysis.
The Charts Themselves
Let’s first examine the basics of any point and figure chart.
If the stock, sector, or market breadth indicator is rising in price, the chart
will be in Xs, if the stock (sector or market breadth indicator) is falling in
price, the chart will be in zeroes. There is not necessarily a notation made on
the chart every day (a much different concept than every other charting method).
The general scaling system is as follows: each movement is worth one point AND
the stock must move three points in order to move from being in a column of Xs
to being in a column of Os and vice versa. The “one point†is often referred to
as “one boxâ€, and the three points is “three boxes†because with some stocks,
sectors, and market breadth indicators, the boxes are worth 2 points or ½ point
(.50) and so on. In order to simplify things, I am going to base the discussion
on boxes that are worth one point. The general concept is the same regardless of
box size.
Earlier I mentioned that a notation is not necessarily made on
the chart every day in order to emphasize that difference from other charting
methods. Here is why: If a stock does not move on to the next dollar amount
during the day, then no mark is recorded. For example, if the stock closes on
Monday at $32 and on Tuesday it opens at $32.02, hits $32.07 intraday, and
closes at $31.99, no new notation is made. If the stock opens at $32.02, hits
$33.00 during the day, and then closes at $31.99, one X is added at the $33.00
level. To change from a column of Xs to a column of Os, the stock in our example
must move from $33 to $30 ($33-3). The movement does not have to occur all in
one day. The stock could be at $33, go to $33.02 the next day, go to $33.51 the
next day, go to $32 the next day, and then, finally, gap down to $30 due to some
earnings release or other extraneous event. When that occurs, the column is
reversed and 3 Os are added to represent the current level of the stock (you
would make Os by the $32, $31, and $30 level). The reversal also doesn’t have to
be that dramatic either. It could be a slow drift. Keep in mind that some slow
moving stocks (sectors, market indicators) could go days, weeks, or even months
without an X or O added to its’ chart. To reverse back to a column of Xs, the
stock in our example would have to go back to $33 ($30+$3). At that point, three
Xs would be drawn at the $31, $32, and $33 level.
Basic Patterns and Trend Lines
A buy signal occurs when a column of Xs is able to rise above
a previous column of Xs. This tells us that there is enough demand for the stock
to push it higher. If a buy signal occurs in a chart that has previously had a
declining trend, a new positive rising trend is established and a “bullish
support†trend line is drawn from where it appears that the stock bottomed
before the new buy signal was issued. This 45-degree angle will serve as support
for the stock for any future declines, and, if it is broken, should be a signal
to sell the stock. In the example on the following chart, the buy signal occurs
at $26.00 and pushes the stock out of the bearish resistance line. A support
line is drawn up from the bottom at the low that occurred in the stock at
$18.50. Another buy signal also occurs at $28.00 (a triple top) reinforcing the
positive trend in the chart.
A sell signal occurs when a column of Os falls below a
previous column of Os. This tells us that there was not enough demand for the
stock to keep it from falling below where it traded previously. If a sell signal
occurs in a chart that has previously had a positive trend AND the sell signal
occurs at the bullish support line, then a “bearish resistance line†is drawn
where it appears that the stock made its top. The 45 degree “ski slope†line
will serve as resistance if the stock tries to rebound. If the stock is able to
break through the resistance, then the stock should be bought. On the following
chart, the first sell signal occurs at $28.00. The bearish resistance line is
then drawn from the top that occurred at $38.00. Another sell signal at $27
reaffirms the negative trend.
Breadth Indicators
There are many breadth indicators in the method, but the main
one is the New York Stock Exchange Bullish Percent. This chart records the
number of stocks on the New York Stock Exchange giving new buy signals. If 6% of
the stocks on the New York Stock Exchange move from being on buy signals to
being on sell signals, the chart will reverse over to Os. This is a negative
sign for the market and defensive action to protect portfolios should be taken.
Traders should raise cash, sell short, or just not buy any new stocks. There are
a variety of ways to handle a reversal to negative in this indicator depending
upon your market posture. If 6% of the stocks on the NYSE give new buy signals
(and the chart is not already in Xs) the chart will reverse back to Xs. This is
a positive sign and traders should be on the offensive (buy stocks). Similar to
oscillators, there are lines of demarcation on this indicator in order to
determine whether or not the market is overbought or oversold. If the indicator
is above 70%, it is considered overbought, if the indicator is below 30%, it is
considered oversold. However, just like oscillators, the trained technician
knows not to act on these levels until the market starts to move away from them.
If you have been in the market long enough, you are aware that things can stay
overbought/oversold for a while.
Sectors
Investors can look at point and figure charts for each index
that is available for each particular sector to determine whether or not that
that is a sector that deserves attention. For example, you can chart
(
BKX |
Quote |
Chart |
News |
PowerRating) (PHLX/KBW
Bank Index),
(
HGX |
Quote |
Chart |
News |
PowerRating) (PHLX Housing Sector), and
(
GOX |
Quote |
Chart |
News |
PowerRating) (CBOE Gold Index) if you would
like. Buy stocks in those sectors if the sector index chart is in a positive
trend.
If you want to take that analysis a step further, point and figure
relative strength charts can be built using the simple relative strength ratio.
If you are unfamiliar with the power of relative strength, let me suggest now
that you familiarize yourself with it thoroughly. What follows is the basics of
how it works: If you have a sector that is trading at 210, while the S&P500 is
trading at 1250, the sector’s relative strength would be 16.8% {(210/1250)*100}.
Suppose within the next couple of days the sector moves to 207 while the market
moves to 1220. The new relative strength would be 16.96%. What happened? Both
the sector and the S&P500 fell, BUT the relative strength of the sector rose.
The sector did not fall by as much as the S&P500, so the sector has “positive
relative strengthâ€. Sectors with positive relative strength are where you want
to be. These relative strength figures can be charted on point and figure charts
similarly to the instructions above in order to find out which sectors are
outperforming the market as a whole on a relative basis. You can also compare
sectors to one another and chart that on a point and figure chart as well in
order to determine which sectors are outperforming one another. For example, you
may want to see if healthcare is outperforming oil on a relative basis. Really,
you can use relative strength to compare just about anything as long as what you
are trying to compare can be measured quantitatively. There are also bullish
percent charts (breadth indicators) available for sectors.
Putting it All Together
Don’t be intimidated by the point and figure method. It is not
much different than other charting methods (bars, lines, candlesticks) in the
basic analysis. But, because of the way the charts are constructed, I have found
that they will help you stay with a rising stock longer than other methods may,
and, perhaps more importantly, help you determine when to get out of a declining
stock. In addition, it is much, much easier to determine when a trend change has
occurred. And, when a trend is actually in force and when it could be expected
to change. Stop points and areas of congestion are much easier to determine than
they are on bar charts. Point and figure charting is just the mapping out of
supply and demand in a clear and concise manner. If you are interested and would
like to learn more, I suggest that you purchase and read Tom Dorsey’s book Point
& Figure Charting. I prefer the First Edition. And, no, I have not received any
monetary consideration from Mr. Dorsey.
Sara Conway
Sara Conway is a
registered representative at a well-known national firm. Her duties
involve managing money for affluent individuals on a discretionary basis.
Currently, she manages about $150 million using various tools of technical
analysis. Mrs. Conway is pursuing her Chartered Market Technician (CMT)
designation and is in the final leg of that pursuit. She uses the Point and
Figure Method as the basis for most of her investment and trading decisions, and
invests based on mostly intermediate and long-term trends. Mrs. Conway
graduated magna cum laude from East Carolina University with a BSBA in finance.