Point and figure (P&F) charts are among the oldest trading tools. They were in use by the late 1800s and they are still widely used by traders. They are valued by traders because they can easily be used to identify the trend and to develop price targets and trading strategies.
We have written about the construction and fundamentals of the P&F chart and we will refer readers to the previous article for a review of the basics. That article can be found here. In this article, we will focus on what the charts tell us about the current state of the stock market.
The first technique we will cover is the more common one used by traders, the horizontal count. This technique is applied after prices break out of a consolidation. A consolidation is a trading range where the price makes little up or down progress for an extended period of time.
A chart of the iShares Russell 2000 ETF (NYSE: IWM) is shown below. This index is shown because small caps tend to lead the market. An analysis of IWM can provide insights into where large caps are headed.
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Without going into detail, we will note that Xs are used to denote up trends and Os represent down trends. Time is ignored on the chart and Xs or Os are added whenever prices move at least $2.
The most recent signal on this chart is a sell signal that occurred when the columns of Os broke to new lows.
To find a price target, we can add the size of the expected price move to the breakout level. The process can be expressed in two formulas:
- Width of pattern * box size * reversal size = A
- Low of consolidation pattern – A = target
For an up side break out of a consolidation pattern, the process is similar. The first step is the same as for up side break outs. The second step involves adding the objective to the high of the pattern. This is summarized below:
- Width of pattern * box size * reversal size = A
- A + High of consolidation pattern = target
This is the basic technique. There are variations that are more aggressive or more conservative but all involve finding the size of the expected move and adding or subtracting that from the consolidation pattern.
In this case, the consolidation extends for just 5 columns. That means with a 3 box reversal, the objective is $116, which is ($146 – (5*2*3)).
SPDR S&P 500 ETF (NYSE: SPY) is an ETF that tracks the S&P 500, one of the most widely followed stock market indexes. The chart of this ETF is shown next.
Here, the story is less clear. The ETF has been in an extended consolidation for some time.
The most recent column is one consisting of Os so this is a short term down trend. Here, we also see an extended consolidation, this one consisting of ten columns. That indicates we expect a large move when the break out occurs.
Based on the chart, a break out could be expected when prices break above $284 or below $256. We are much closer to the down side break than the up side break. This confirms the cautious view we obtained from an analysis of IWM.
One More Chart
Finally, we will review the chart of the Invesco QQQ Trust (Nasdaq: QQQ), an ETF that tracks the tech heavy Nasdaq 100 Index. This index assigns a large weighting to recent market leaders including Apple, Facebook, Amazon.com, Netflix, Microsoft and Alphabet parent of Google.
QQQ has completed a down side break out. This chart also shows that the P&F chart can keep an investor in a trend for an extended period of time.
In the chart, you can notice the trend that began in late 2016 and the columns of Xs moved higher and higher. This showed a strong trend and there were no sell signals interrupting that trend.
Now, the question is whether or not a similarly strong trend will develop on the down side. The P&F charts of all three major indexes do show that extended topping patterns are in place. This indicates an extended price move is likely and all three charts favor a down side trend.
The advantage of P&F charts is that they focus solely on the price action. There is no time on the chart so the action shown represents simply the forces of supply and demand. The bases that formed on the indexes is a sign of relative balance between supply and demand.
The relative balance means that bulls and bears are waiting for a clear trade signal. That signal shows up as a break out on the P&F chart. We already have a bearish break out in QQQ. These were the market leaders on the way up and are now leading prices lower.
IWM appears to be next in line for a decisive break, followed then by SPY. This is typical of bear markets where the large caps are the last to show the effects of selling pressure. QQQ is right now warning that selling pressure will spread to QQQ and investors should prepare their bear market plans now.
You may find P&F charts to be useful. But many individuals discover that they are not able to complete the required amount of research because that can take an extended amount of time and they have other personal and professional commitments competing for their time.
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