Option Investor
Trader's Corner

Point and Figure - Formations

Printer friendly version

First of all I would like to apologize for the P&F Support and Resistance article posted March 14th. Somehow all the tabs in the Word document were deleted when it was posted to the newsletter and the diagrams I constructed were useless as I'm sure you all noticed. Please go back and see that indeed it has been fixed and the article now makes sense. I think this article on support and resistance is one of the most important articles on P&F for you can use it to confirm your analysis that a stock is bullish, bearish or just about to turn.

With that out of the way, I hope you have been enjoying reading this series as much as I have enjoyed writing it. As I promised in my last article we will be discussing double and triple bottoms and tops, catapults and triangles.

The goal of technical analysis and P&F Charting is to reveal if the bulls or the bears are in control and where the most likely spot is for a reversal. But up until now we have not had a way of determining when to buy or when to sell. That would be helpful wouldn't it?

Double Top

Lets start with the most simple of P&F formations the Double top. It is just like the double top you see in the bar charts and the one you will see the most often.

Notice there are two columns of X's separated by one column of O's. Both columns of X's rise to the same spot, the $40 box. That's the Double Top and the absolute minimum required to identify this top.

But let's look at it a little closer. Starting with the first column of X's, we can see that buyers pushed the price from $35 to $40 or the buyers wanted more shares at $35 than sellers were willing to sell for $35. Buyers bid prices higher until sellers were willing to relinquish enough shares to satisfy the demand. There was no more demand for the stock above $40 or otherwise it would have gone higher. In fact, at $40, sellers offered more shares than buyers were willing to buy. The stock met resistance at $40 and retreated. The column of O's shows the retreat. Buyers were exhausted. The price fell until buyers could be found at $36 or just below $36 but not to $35. Here the buyers became interested again. You could say the stock found support at $36. You could also say the stock found a bottom at $36.

The next column of X's is where this situation becomes interesting. You can see that buyers bid the price back up to the $40 mark. We now have two tops at $40, a Double Top. Then what happens next is the key to understanding the supply and demand situation. If the stock meets resistance and reverses again, it means there are still too many shares for sale at $40 but if the buyers bid the price above the $40 mark, it means they had to bid the price higher to satisfy all of the demand for the stock. This would be interpreted as very bullish. In fact, it would be a buy signal and would look like this:

Double Top Buy Signal

Of course, you'd like more information before actually making a purchase decision. But in the absence of any other information, this single penetration of the Double Top is a bullish chart pattern and a buy signal.

Double Bottom

The Double Bottom looks like the opposite of a double top as you would expect. The bottom is formed when two columns of O's fall to the same spot. In the example above, that spot is the $36 box.

For a Double Bottom to form, the whole supply / demand situation is reversed from the Double Top example. Sellers offered too many shares for buyers to absorb. The excess supply drove the price down to find equilibrium with demand. The first instance of that in our example is at $36, where buyers again showed interest in the stock. The stock found support at $36 and formed a bottom then retraced shown by the column of Xs. So while buyers bid up the price from $36 to $39, there was no demand for the stock above $39. In fact, at $39, sellers offered more shares than buyers were willing to buy forcing the stock back down again. The stock met resistance at $39.

Finally, you can see that sellers drove the price down to $36 again to form a second bottom, a Double Bottom. The Double Bottom is another important P&F chart pattern. If sellers continue to offer more stock than buyers are willing to absorb, the price will fall further. If the price were to fall to $35, that would be a sell signal.

Double Bottom Sell Signal

This single penetration of the Double Bottom is a bearish chart pattern and a sell signal.

Triple Top

When a stock advances and is repelled three times as it reaches resistance at the same point, it will make three tops. That is an obvious Triple Top.

In this example, the Triple Top is at $40. When the stock moves to $41 and penetrates the Triple Top, this indicates that the number of shares available for sale is not meeting the demand. Buyers see the price rising and still want to buy additional shares. Demand outweighs supply.

Triple Top Buy Signal

This indicator, a penetration of a Triple Top, is a buy signal.

Triple Bottom

The same is true to the downside. If a stock encounters support at a certain point, reverses, and tests that support level two more times, the stock will form a Triple Bottom. If penetrated, the resulting sell signal is a good indicator that buyer's demand for this stock is being overwhelmed by the number of shares offered by sellers.

Triple Bottom Sell Signal

A Purdue University study performed by Professor Earl Davis constructed a table of 'probabilities' associated with various 'sell signals' and 'buy signals.' In a bear market a 'triple bottom sell signal' was profitable (in a bearish trade) 93.5% of the time, with an average gain of 23% over an average 3.4-month timeframe." I like those kinds of odds.

As you probably have noticed the tops are always made with the Xs and the bottoms with the Os since Xs denotes demand and Os supply.

Bullish Catapult

There are endless variations on these chart patterns. Here's an example where two chart patterns are combined to form a third pattern that reinforces the interpretation of the prevailing trend.

A Bullish Catapult is nothing more than a Triple Top followed by a Double Top.

The Double Top following a Triple Top is a confirmation that the number of shares available for sale is not keeping up with demand. Buyers want to buy more than sellers are offering to sell so the price increases to entice the sellers into parting with their supply.

Notice in this example the higher highs and the higher lows. Demand for this stock is increasing and supply cannot keep up with it. People who don't own it want to own it and are willing to buy at just about any price.

Bearish Catapult

On the downside, a Triple Bottom followed immediately by a Double Bottom is called the Bearish Catapult.

Notice in this example the lower highs and the lower lows. Demand for this stock is drying up. People who own it want to get out of it. They're now willing to sell at just about any price.

Bearish Triangle

I P&F formation I like the best is the Triangle because they are easy to identify visually. The only constraint on the triangle is that it must have 5 columns, although I don't usually hold a stock to this constraint and if I see a nicely formed triangle with only 4 columns I would still consider trading it.

Let's start with the Bearish formation, for a change. Notice the higher lows and lower highs in the example.

If you'd guessed that this pattern could go either way you would have been right so you have to wait for a resolution before entering a trade. But once the chart signals a direction, you have a good entry point. More importantly, you have a fairly close stop point if the trade doesn't work out.

In the Bearish Triangle example, you will usually have a Double Bottom sell signal as your trigger. Notice the double bottom at $34.

Here is a real life example of the bearish triangle.

I have marked the triangle with magenta arrows. Notice also that Stockcharts.com will tell you when this triangle breaks out, which is marked with a blue arrow. Did you notice the triangle breakout was at the double bottom breakout.

The only problem with this triangle is that it is above a bullish support line. I would be more inclined to trade this bearish triangle when the bullish support line breaks.

Bullish Triangle

Here's the same triangle example, except this time the chart resolved to the upside.

In the Bullish Triangle example, you will usually have a Double Top buy signal as your trigger. Notice the double Top at $38.

Here is a real life example of the Bullish Triangle.

I have marked the triangle with magenta arrows. Notice also that Stockcharts.com will tell you when this triangle breaks out and the double top.

If you are looking for charts with clearly defined buy and sell signals or charts that only display the most significant price movements, Point & Figure charts may be just the ticket. While the columns of Xs and Os on a P&F chart may seem unfamiliar at first, with a little practice you may begin to wonder how you ever lived without them.

Next week I hope to finish off the series with how to use P&F charts to determine price projections. However, I'm not sure I will be able to fulfill this goal however, because I am having a hard time finding the data I need.

Trader's Corner Archives