Last week, I mentioned that I almost always choose candlestick charts over the other possibilities available on my charting service. That's true when I'm trading options on an equity index, but when I occasionally foray into an equity trade, I often scan another type of chart. That would be the point-and-figure chart.
I'm no expert on point-and-figure charts, but I do like the overview they provide. Neither time nor volume matter in a point-and-figure chart, and you won't find moving averages or traditional indicators and oscillators such as RSI on most point-and-figure charts, either. What you will find are rising columns of X's and descending columns of O's and an occasional red or blue trendline.
Point and Figure Chart of the SPX as of 7/20/09:
Each square on the chart represents a price movement of a certain number of points. Until a price movement of that size occurs, no new X or O is added to a column. The size of the movement required varies according to the price of the underlying.
Most charting systems that offer point-and-figure (P&F) charts offer automatic scaling. Experienced P&F chartists might like to set their own scaling preference, but I tend to let the charting service do that for me.
Many charting services would require a new 5-point rise in the SPX before a new X is added to the column of X's currently being built. A stock priced above $20.00 and at or under $100 would typically require only a 1-point move in the direction of the current column before a new X or O was added.
Once a column of X's is being built, a three-box reversal is required to start a column of O's, and once a column of O's begins being built, a three-box reversal is required to start a column of X's. Again, many charting services allow expert P&F chartists familiar with the behavior of a particular underlying to input different parameters for a reversal, but I tend to use the default standard of a three-box reversal since I would never go so far as to typify myself as an expert P&F chartist.
All trendlines are at 45-degree angles. The rising blue trendline seen above is a bullish support line, and the descending red trendline is a bearish resistance line.
Buy or sell signals are created when a column of X's rise above a previous column of X's or a column of O's drop below a previous column of O's. A price objective will then begin to be created. I treat these price objectives the same way I treat potential targets on my nested Keltner channels or those determined from a chart formation found on a traditional price chart. If I see prices break out of a rectangular consolidation formation on a traditional price chart, for example, I know that there's vulnerability for prices to climb or fall a distance equal to the width of the rectangle. That helps guide my decisions, determining when I might want to begin stepping out of position or how vulnerable I am to an adverse move if I was already in a position going the opposite direction. I don't count on prices to move exactly to the price objective. Neither do I count on them stopping there, if they do. So, I don't necessarily expect prices to either reach a price objective on a P&F chart or stop there, if it is reached. I think of vulnerabilities to that level.
Finding the price objective can be somewhat tricky. The topic required a separate article of its own when discussed in a 2005 series on P&F charts in Option Investor. I'll be linking traders to that series later, but here I should note that some charting services list the upside or downside price objective, as does the one shown in the chart shown in this article. That price objective for the SPX was 1115 at the time the chart was snapped in mid July, but that's not yet the final price objective. That won't be established until there's a first three-box reversal. As of the pre-market hours Friday, July 31, 2009, when this article was being edited, the bullish price objective had moved to 1250. It looked as if the SPX's end-of-day descent on the previous day had barely avoided the first three-box reversal since July's rally had begun. Until that reversal occurs, a higher price objective than the 1250 remains possible.
Subscribers might also have noticed that the chart includes some small numbers 1-9 and letters A,B and C. Since time is not plotted on the horizontal axis of these graphs, these designations are added to give chartists some idea of when certain actions occurred. The numbers 1-9 represent the months January through September, with the letters A-C representing the months October through December. We can see that July began with a column of O's being created and continued with a reversal into a column of X's. The chart doesn't designate when in July the reversal occurred.
That's enough of a background to be able to determine as much information as I do when I glance at a P&F chart. What I see shows me that the SPX is above bullish support, in a column of X's and on a current buy signal, having created a double-top breakout signal on July 16. This charting service determines that there's a preliminary bullish price objective of 1115, now 1250. Careful, though, as there has not yet been a first three-box reversal. That means the SPX may be vulnerable to such a pullback soon, but it also means that bears should be aware that the potential upside price objective may yet be higher than 1250. That column of X's has begun to look a bit extended to me, but since I'm a casual observer of P&F charts, examining them only for the overview they provide, I can't verify whether that observation is or isn't valid.
Most P&F enthusiasts like P&F charts because they filter out all the little back-and-forth movements and concentrate on the main trend. I like to use them as a place to start when reviewing an equity's performance because they give me that overview. Speaking in general and not in reference to a specific trade suggestion, I can't argue with the sometimes-employed tactic of fading a trend if a trader's analysis tells that trader that it's time for a reversal, as long as stops that keep the trade from getting into too much trouble are in place. However, if one is going to attempt such a tactic, it should be attempted only in the context of the overall trend. The P&F chart gives a quick snapshot of that trend and proves useful for that reason.
P&F charts might filter out a lot of noise from small price movements, establishing the main trend, but I don't like the fact that they also filter out the volume. There's no volume confirmation or non-confirmation of the signals. So, while I'll look at the P&F charts to get an overall view of the prevailing trend, it's just one stop on the way to forming a judgment about what's happening. I once asked a P&F fan how he felt about no volume confirmations and he answered that "volume was overrated," but that's not my viewpoint. In fact, mine would be the polar opposite.
Just as with all other charts, this overall view provided by the P&F charts is not infallible. If one looks at the far right of this chart, it is apparent that the second column, a column of X's, was producing a strong buy signal with a projected-higher price objective before January's reversal into a column of O's. Another buy signal was created in February, when a column of X's had risen above another X column. Neither of the two tentative upside price objectives was to be achieved, however, before new downside price objectives were established and markets cratered into March lows. Other times, I've been surprised when I thought that the chopping back and forth was indicating a range-bound markets to see that the P&F charts were pinpointing a trend in place and was able to adjust my plans accordingly. So, use these but treat the information as you would other information garnered from other sources.
If you're intrigued by what a P&F chart can or can't do, you might want to read about them in more depth. You're in luck. An OI staff member wrote a most instructive 7-part series on P&F charts in 2005. Although some of the chart links are broken, I still think the series has much to offer the trader investigating the usefulness of P&F charting. The series consists of Article 1, Article 2, Article 3, Article 4, Article 5, Article 6, and Article 7. In addition, Thomas J. Dorsey's Point & Figure Charting is an often-sought-out resource on this type of charting method.