This article is a continuation of my Wednesday Trader's Corner article of last week (8/30/06) and discusses some of the key benefits and a key advantage of projecting price targets offered by Point & Figure (P&F) charts. The first article on this topic was in answer to a subscriber's question and described the basics of constructing Point & Figure (P&F) charts. That article is the preface to this one and may be seen by going back to your saved Option Investor Daily market letter or by clicking here when also connected to the Internet.
OIN's Jeff Bailey uses P&F charts extensively in his Market Wrap columns and the aforementioned article can provide the basics in how these charts display price-only data as changes occur of a certain magnitude, as opposed to price by date plotting seen in bar, candlestick and line (close-only) charts.
Key aspects in Point & Figure chart construction:
1. All trading is seen as a single stream of prices and ignores the time duration an index or stock takes to get from one price to another. Moving average or other studies that use 'time', don't apply to P&F charts.
2. The P&F chart is constructed by a serried of Xs and Os. Each X or O represents a price move of a given amount, determined by the user; e.g., '1', as in a 1 Index point in the OEX, called the BOX size. An 'X' is equal to an advance of the box size, an 'O' is used to mark a decline of the amount of the box size.
3. New Xs or Os keep getting filled in as long any NEW high or low is equal to or more than the box size.
4. A second key element, besides the box size, is the REVERSAL amount, which is usually quoted as a multiple of the box size amount; e.g., 3 in the case of the commonly used 1X3 P&F chart above.
5. Assume the market has been advancing and we're using a 1X3 P&F chart. Comes a price pullback equal to 3 index points in OEX below the value represented by the highest high and the topmost X; a new column of at least 3 Os is made 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.
6. 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 reference to dates on the bottom of a P&F chart is not a time 'scale' in the sense in which it is normally used (one that marks regular increments of time like days). Rather, the dates noted to the right of the little slash marks represent the beginning of a new column.
SOME BENEFITS OFFERED BY POINT & FIGURE CHARTING
#1, Finding support and resistance areas:
Point and Figure charts are quite useful in highlighting and defining areas of price resistance. For example, a price area where there is more stock for sale than buyers can absorb and where sellers will 'distribute' a substantial amount of stock to all willing buyers. In areas of price support, buyers will purchase or 'accumulate' as much stock as sellers will offer. Both distribution and accumulation price zones are where P&F reversals occur as shown by a new column of X's or O's.
The chart below of Microsoft (MSFT) provides an example of clear-cut definitions of the price areas where the stock has been under accumulation and distribution in the last several years. The same areas of support and resistance of course can be seen on bar charts, but with the P&F chart, there is no time duration to obscure what is happening and the information on price support and resistance 'pops out' visually with the use of this type chart.
Point and figure charts allow horizontal measurement across the chart to determine upside or downside price targets. This is mostly unique to P&F charts.
The premise here is that there is a direct relationship between the WIDTH of a sideways or horizontal trend (how long it goes on) and the subsequent price swing up or down when prices begin their next advance or decline. An equal measurement to width is made on the vertical price scale. So as not to mystify this and go back to market psychology and dynamics, the longer the tug of war goes on between buyers and sellers, the more pronounced will tend to be the buying or selling interest when it ends; we all know what happens when you let go of the rope in a tug of war game.
In the next chart, the count of the number of boxes in different columns is across the middle of an area where prices are trending sideways, which is also referred to as a (price)'congestion' area. Determine which horizontal line has the most number of Xs and Os filled in, then count the total number of 'boxes' across, whether filled or empty.
When there is a rally or decline that then moves above or below this line with a new X or new 0, count the same number of boxes on the vertical price scale (up or down), to arrive at a minimum price objective. The projected price objective is equaled or exceeded more often than not in my experience. Occasionally the 'minimum' price objective is not quite reached. What I describe is not all there is too measuring techniques in P&F charts, but it is the most useful to trading in my estimation.
Such 'signals' are generated when a column of Xs rises one box higher than the highest X of the prior 'X' column. Trading sell signals are generated when a column of Os declines one box below the lowest O of the prior 'O' column.
Since the reversal size is defined, the point where a new X would be added is known, an order to buy can be in place just above that price. Such a move could be used as a signal to initiate a new long position in a stock or as an indication to buy calls. This is a good way to set stops. If support in the OEX is seen at 600 in a 1X3 P&F chart, a decline 3 points below that level, or to below 597, would suggest the beginnings of a downside reversal.
For example, trendlines and channel lines can provide added clarity with Point & Figure charts and upside or downside breakouts are clearly seen.
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