Some charts indicate the possibility that stocks could continue to rally over the long term. Even if the market sets a course higher, bullish or bearish short-term trades can be made along the way. If you'd like to generate more trading opportunities, consider the unique point & figure (P&F) technique.
Point & figure primer
But P&F charts are not some new, fly-by-night technique. They were used as far back as the late 1800s by Charles Dow, the father of technical analysis and founder of the Wall Street Journal. Proponents value them for their flexibility and ability to eliminate much of the noise that can distract the user from identifying what is happening with the price of the security. Simply, they offer another way to trade the market.
Compared with normal line and bar charts, P&F charts appear quite different. In fact, you might be confused when looking at such a chart for the first time because there are typically no dates (see the chart below).
While this might seem like a daunting chart, it’s really not once you understand how it is constructed. New plots are made on a P&F chart only when the price changes by a designated amount. A new mark, or box, is added only when the price has moved by an amount equal to or more than the specified box size.
For example, assume that for a particular P&F chart, $1 equals one box. If XYZ Company’s stock increased by $1, a 1-box chart would produce one new “X” mark. An X marks an up move, while an “O” delineates a down move.
A note about box size.
If you were using a 5-box chart, where one box would be plotted only when there is a $5 move, a price increase of $1 would not result in an X mark being placed. Instead, the stock would have to increase by at least $5 in order for a new X mark to be plotted on a 5-box chart. Daily highs and lows are used for determining price changes, rather than closing prices.
A few P&F concepts to know
Box size is one of the key determinations to be made when constructing your chart. In P&F charting, box size determines the sensitivity and frequency of trading signals. In our previous example, recall how a $1 increase in the stock would have resulted in one new X mark on a 1-box chart, but not on a 5-box chart.
Reversal size is another key component of a P&F chart. This is the number of boxes by which the price must move before a reversal and the beginning of a new column to the right. For example, on a 3-box reversal chart in a column of Xs, the price would need to move at least three boxes lower before you could begin a new column of Os. Alternatively, in a column of Os, you would need to move at least three boxes higher before you could plot a new column of Xs. There are no price reversals below some predetermined, minimum value.
Box size and reversal size may be stated on the chart. For example, a 5 x 3 chart stands for a 5-box size and 3-box reversal. This translates to a box size of 5 (where each X or O represents a five-point move) and at least 3 boxes must be plotted in each column before a reversal and a new column is begun. Consequently, a 5 x 3 chart would require a 15-point move (5 x 3) in the security price for a reversal to take place. Similarly, a 1 x 1 chart would require just a 1-point move in the opposite direction for a reversal to take place.
Choose box and reversal size carefully
There are a few ways to manage a P&F chart, depending on your strategy. Sensitivity, or how frequently you’d like to generate trading signals, is dependent on your box and reversal size choices. If you are looking for frequent trading signals (e.g., an intraday trading strategy), a smaller box and reversal size might be appropriate. To increase the sensitivity of a 5 x 3 chart, for example, you could decrease the box size to 3 x 1.
A 1 x 1 chart would be the smallest and most sensitive chart that can be constructed. The main advantage of a 1-box reversal chart is obtaining price objectives using a horizontal count. We’ll cover price targets shortly.
Box and reversal size will also play a significant role in how a chart looks, and, potentially, in the validity of patterns. Breakouts from bigger congestion zones are more significant compared with a breakout from a less congested area, and wider patterns generally produce stronger breakout signals.
What to look for
A note about price targets.
Once you get used to how these charts look, it’s possible to apply many traditional technical analysis techniques. Head and shoulders patterns, moving averages, and fulcrums, for example, are found in P&F charts. A few other techniques are exclusive to simplified box P&F charts, including trend lines that may be drawn at a 45-degree angle on 3-box charts. P&F charts can be useful for identifying support and resistance levels, breakouts, and price targets.
“There are three primary things to look for when evaluating a point and figure chart," says David Keller, CMT, president of the Market Technicians Association and managing director of technical research at Fidelity. "They are the trend, the trend lines, and the price targets.”
How to identify price targets using a P&F chart
The count method is a way to determine price targets on P&F charts. This is a means of anticipating the expected price move using the length of the pattern, reversal size, and a point on the chart.
To determine price targets, there are two basic methods: horizontal and vertical counts.
- Horizontal count method: According to Jeremy Du Plessis, author of “The Definitive Guide to Point and Figure,” one way to determine a price target is to count the number of columns in the pattern (see the note, above right). Then multiply the number of columns by the reversal box size, and add that number to (or subtract from for a downtrend) the price of the lowest O (or the highest X for a downtrend) in the pattern. Suppose that the width of the pattern is 7 columns, the reversal box size is 3, and the lowest O in the pattern is $20. The horizontal price target would then be 41 ([7 x 3] + 20).
- Vertical count method calculation: Instead of counting the columns in the pattern, count the number of boxes in the predetermined column for the vertical count method. Then, multiply the number of boxes by the reversal box size, and add that number to (or subtract from for a downtrend pattern) the price of the bottom box (or the top box for a downtrend) of the column that is to the left of the column with the most boxes. Suppose that the number of boxes in the column is 10, the reversal box size is 3, and the bottom box of an O column that is next to the chosen X column is $20. The horizontal price target would then be 50 ([10 x 3] + 20).
These methods generate specific price targets; however, that does not mean the price will certainly rise or fall to the target. Price targets can be useful for identifying the general direction and range that a security might go. For instance, if after a short uptrend the price begins to decline, the price at which the trend might change to neutral is right below the base of the beginning of the short uptrend. A price target can narrow the range as to where the security might then reach.
Applying point & figure
In terms of current P&F application, Keller notes that that “on a 10-point point and figure chart of the S&P 500, we had a bullish signal in July when the index broke above 1,660 for a double top breakout.” Indeed, the market rallied throughout July into early August.
Keller thinks the longer-term bullish trend may persist. “The S&P is well above the 45-degree trend line from the October 2012 low, and is also above the secondary trend line from the June 2013 low. In terms of a price objective, a vertical count using the last two significant uptrends suggests a minimum upside target of 1,960.” Keller adds that as long as the S&P stays above 1,640, this trend could remain in place.
P&F is another tool in the toolbox
To be sure, P&F charts are not for everyone as this type of analysis requires some getting used to. There are some drawbacks as well. For instance, volume is not considered, and P&F charts are not good for identifying whether a stock is being accumulated (bought) or distributed (sold).
However, if you’d like to execute a unique type of technical analysis, you can use P&F charts to generate buy and sell signals and identify price targets.