I am working on answering some question from my Subscriber 'mailbag'. Last week (see the 8/23 Option Investor Daily e-mail or go to the web site) I wrote on the use of market 'sentiment' as an aid to seeing impending trend changes or continuations of the existing trends. This week I'll answer the question on the basics of how to construct and interpret Point & Figure (P&F) charts, which OIN's Jeff Bailey uses a lot.
By the way, I saw an encouraging CBOE equities call to put volume figure yesterday (Tues): put volume jumped, possibly as a result of the S&P 100 (OEX) nearing its prior high (and the possibility of a 'double top') and the overbought RSI reading seen in my first chart below. The resulting dip in my (equities call/put) sentiment indicator, in the face of an ongoing and still-strong advance, I took as an indication that there would be breakouts to new highs for this move, which did in fact happen today in all the major indices except for the OEX.
Very often it's the case that the strongest moves occur when there is trader 'caution' on the way up. Market sentiment or the outlook on the near to intermediate trend by traders especially, is a good, if the not the best, way to measure if bullish sentiment is getting extreme on a rally. It's not here, as seen by how far under yet my lowermost (sentiment) indicator is from the upper line of an extremely bullish sentiment, which would be a situation suggesting an 'overbought' extreme and where we need be wary of a (downside) reversal.
Later, 'Xs', referred to as 'points', were inserted in the place of prices: this technique became known as the "point and figure" method of charting. As with Candlestick charting, the full subject is better covered in an introductory technical analysis book at least; dare I suggest mine: Essential Technical Analysis!
If you get keenly interested in this charting technique and have charting software that displays the price data correctly for this chart type, I would suggest further reading and study of P&F charts. Chartcraft as far as I know is still sending out weekly updated P&F chart books on stocks to subscribers using the '3-point' reversal standard.
Point and Figure (P&F) charts essentially views all trading as a single stream of prices and ignores the time duration it take to get from price point A to point B. You can also apply to P&F many of the technical analysis techniques that relate to chart patterns and chart 'markings' like trendlines. Some, or many analysis techniques CANNOT be used as they reference the passage of time; e.g., moving averages. Also, volume (of trading) is never accounted for either. On the other hand there are some techniques of projecting future price movements that are unique to P&F charting.
On the chart, every X or O is equal to a price move of ONE index point: an X is an advance of this amount, an O is a decline of this much. As long as prices continue to advance by one point (or $1 in the case of stocks) or more, an X is added above the X in the box below it in the same column.
Boxes do not get filled in partially, but new Xs or Os keep getting filled in as long any NEW high or low is equal to or more than the box size. The chart here reflects price changes that occur based on HOURLY data. It could be DAILY data as well, which in fact is most common. I happen to save a LOT of hourly data; for example, I can go back 3 years of more in this manner. If you have the data for it, you can in most charting applications specify that the box size apply to prices registered in a period less than a day, as in this chart based on hourly price changes.
The most notable thing with the OEX P&F chart here is that, based on this chart type, OEX broke out to a new high today. You can compare this to the daily bar chart above, where this is NOT the case and the possibility of a double top formation is of more concern; especially to those holding OEX calls!
Trendlines, such as seen above, are used in P&F charts as frequently as in 'line' (close-only) charts, bar and candlestick charts.
THE REVERSAL CRITERIA OR AMOUNT
The second key element besides the box size is the reversal amount, which is most often quoted as a multiple of the box size amount; e.g., 3 in the case of the commonly used 1X3 P&F chart above.
This means that when the market is advancing and there is a price decline equal to 3 index points (or $3 or more in a stock) BELOW the value represented by the highest high and the topmost X, a new column of at least 3 Os is made and recorded in the next column to the right in a descending manner.
The reverse is true of descending boxes with Os: a rally from the lowest box with an O of 3 points or more (or, whatever is the reversal amount), will result in a new column to the right with 3 or more Xs plotted.
You may notice that the X and O columns always begin one box up or down from the end of the prior column its a convention of P&F charting to start the new column this way. The box size and reversal size is described as 1 by 3 (1 X 3) as noted above the chart. The box and reversal size could be 1X5, 1X6, 2X10, etc. In the OEX 1X3 P&F chart above, the number of Os will have to equal AT LEAST 3, but will be whatever the decline is in terms of the box size (e.g., 5, 10, etc.) BEFORE the next reversal occurs that's equal to what has been set as the reversal amount.
Youll note that there is a reference to dates on the bottom, on the time (horizontal) axis. This is not a time 'scale' in the sense in which it is normally used; i.e., one that marks regular increments of time, say days or weeks. Rather, the dates noted to the right of the little slash marks represent the beginning of a new column. A 'pure' P&F chart would have NO dates noted at all. However, a time reference is useful and no doubt what most traders use; my TradeStation charting application gives such dates automatically.
A box size could be greater than or less than 1. An example of a box size of .25, allows the recording of smaller price moves and is especially useful in the case of lower priced stocks, is shown below with Cisco Systems (CSCO). Here, each X or O denotes a quarter point price change. DAILY data was used only to construct the CSCO .25X3 P&F chart; as opposed to intraday price changes such as hourly.
It's interesting to note that once the leftmost down trendline was pierced to the upside, a subsequent pullback to that trendline acted as support and was a good spot to buy calls. While a bar chart more or less indicated the 'line' of support that kept showing up in CSCO around 17-17.25, this was MOST clear or pronounced on the P&F chart below.
The 'reversal' size of 3 remains the same in the chart above as in the prior chart: it takes a reversal in price of 3 times .25 or .75 to cause another column shift to the right and a change to the opposite figure such as from Xs to Os. The result of this is that we now see that a more detailed view of the price changes that occurred in the stock.
Variation of the reversal size will also make a significant difference and a large reversal amount can encompass many years of trading as can be seen in my next chart.
This next chart, which is of IBM, also has a box size of 1, but a reversal size of 10 and displays about 8 years of price history on the same size chart as the earlier examples. Some or much of the detail is lost and only the bigger trend changes are seen.
This is suitable for an investor with a long-term horizon; a larger reversal amount is going to be preferred. A chart with a large reversal amount shows the broad long-term price trend, which in this case is still down, relative to the late-90's/2000 top, in line with the S&P.
This is a good stopping point, as I will follow up in my next week (Wednesday) Trader's Corner article and go into the unique advantages of Point and Figure charts, which to me especially centers on determining upside or downside objectives by using horizontal measurements ACROSS the chart to determine upside or downside price targets.
Meanwhile, I suggest that you might look at some to the stock or indexes you follow closely and chart the same items with a Point & Figure chart, starting with the common 1X3 box/reversal size. The idea is to note what shows up in the P&F chart that is different and potentially useful relative to the standard bar or candlestick charts; for example, a clearer definition of support, of resistance, trendlines, etc.
In the meantime, Good Trading Success!
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