Today’s Trading Lesson From TradingMarkets

Editor’s Note:

Brice

Some readers might think I’ve taken some old
book down from the shelf and blown the dust off it to write this lesson, but the
truth is Point and Figure charting is alive and well. In my opinion, this method
of technical analysis is a great way to stay focused on the markets. The basic
idea behind Point and Figure charting is to eliminate insignificant movement in
the market and expose  the real battle between the bulls and the bears. If you
take the time to understand the concepts behind the system, it can be a tool to
keep your judgment clear of the “noise” that builds up from constant analysis.

This lesson will
cover the basics of creating Point and Figure charts.

When I told someone
in the office I was doing a lesson on Point and Figure charting, they said,
“Aha! Point and figure out where your money went!” The truth is: Nothing is a
sure thing in the world of trading. A surprising number of successful
professionals use this tool for exactly what it is — a logical and organized
way to understand supply and demand. Only significant price movements are
accounted for, filtering out the irrelevant jives and jukes of the market. For
this reason, less subjectivity is involved in identifying patterns.

Like every strategy
trying to conquer the enigma of the markets, Point and Figure charting has its
limits. There is no volume accounted for and the element of time is not
represented in linear fashion. This shouldn’t be an issue, if you use
traditional bar and candlestick charts as well. I like Point and Figure charting
for following sectors. By keeping a steady handle on where the indexes are, I am
able to base my other strategies.

It is not certain as
to exactly when Point and Figure charting came about. Charles Dow called it the
“book method” in 1901, claiming it had been around for 15 years — giving it a
birth date of 1886. Victor deVilliers gave the method its modern name in his
1933 classic The Point and Figure Method of Anticipating Stock Price
Movements. It is also rumored that in 1901, legendary trader James R. Keene
used the charts to promote the stock for Andrew Carnegie who hired him to sell
huge amounts of equity, without crashing the price. Point and Figure charting is
the oldest form of Western technical analysis.

The Basics

The best way to
learn Point and Figure charting is to actually make them yourself. At first the
concepts may seem a little obscure, but with practice, you will find them to be
extremely logical. The main components of the system are X’s and O’s:

Either an X or an O
will be put in a “box” to designate the appropriate price action. Each column
represents either bullish or bearish action, so X’s and O’s will always remain
in their own column.

Each “box”
represents a price range. The range is decided upon by the creator of the chart.
The smaller the “box size,” the more sensitive and suitable the signals will be
for shorter-term trading. In general, these guidelines are followed for the
traditional method:

The price values are
never rounded, in other words 4.95 would be a 4, not a 5.

The last component
of the system is the “reversal number.” This is also decided upon by the chart
creator. This number designates the number of boxes the price action must
reverse in a column to confirm a shift to the next column, which will be the
opposite direction. Traditionally the reversal number is 3. So if in a bullish
column of  X’s, the price action must hit a new low by 3 points to merit a move
over to a new column, which will be bearish. The smaller the reversal number,
the more sensitive the chart will be. Someone working with a shorter trading
time frame may want to adjust this technique for his or her own needs. Although
this may seem a little confusing at first, the following flow chart maps out the
process:

Now let’s go through
the process with the example below:

Examples

The first example is
a Point and Figure Chart of The Amex Oil  Index ($XOI):

Notice the box size
here is 5 and the reversal number is 3. The numbers represent the different
months, 1 being January, 7 July, etc. (A, B, and C are used to represent
October, November, and December). As you can see the Oil Index is experiencing a
pullback, and it won’t turn bullish until 3 boxes of upward movement are made to
create a new column.

Next  is an example
of Johnson & Johnson (JNJ):

The price action
here suggests it is on the verge of breaking into higher territory. Notice the
boxes have a value of 1 and the 3 box reversal is in effect. The benefit of
these charts is simplicity. With just a glance, I am able to understand whether
the bulls or bears are in charge without the noise of day-to-day movement that
can often create a hectic picture.

Lastly is an example
of Hewlett Packard (HWP):

 

The boxes have a
value of 1, and the 3 box reversal is in effect. The price action here has been
dominated by the bears. The long column of O’s (three from the right) represent
a strong drive by the bears. I wouldn’t think about going long with this stock
until I saw a turn around by the bulls beginning to take shape in a similar
fashion.

I believe Point and
Figure charting should be used used in conjunction with other forms of technical
analysis such as bar and candlestick charts. In the age of computers, it’s not
hard to find software that will create these charts for you, but you might even
want to consider doing them by hand. I only say this because it’s a good
discipline to keep track of the markets and stay focused on the daily movement.
In addition, Point and Figure charts have their own chart patterns that are too
involved to be discussed in this lesson. The more knowledge you can obtain of
different forms of technical analysis, the stronger you will be as a trader. The
more green lights you have signaling a move in a market, the more likely it will
happen.