Traders often look at price charts. Their goal is to identify the direction of the trend. It’s a simple goal, and often a straightforward task to determine whether the trend is up or down.
In the chart below, we see the iShares Russell 2000 Index Fund (NYSE: IWM). The trend appears to be breaking out to the upside after months of consolidation.
This is one of the most popular charts, drawn in a style known as candlesticks. For a candlestick chart, the range between the opening and closing price is drawn as a rectangle. In the chart above it is colored green if the close is above the open and red when the open is below the close.
A new candlestick is drawn each day. This presents a record of a stock or an ETF’s price action over time. But, the trade who is interested only in the direction of the trend doesn’t need to have a record over time. In fact, they could ignore time and look only at the price action for that information.
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Point and Figure Charts Ignore Time
There are some charting styles that ignore time. Among the oldest is the style known as point and figure (P&F) charts. An example is shown below.
In a P&F chart, traders use columns of Xs and Os to show the price action. These charts were used by traders in the 1800s. On the exchange floor, they could quickly use the Xs and Os to track the price action. They plotted each price move and always had the trend available this way.
In the earliest work, the P&F charts used every trade. But, there are simply too many trades in the modern era to apply that technique. By the 1960s, a shortcut was widely used and that technique is now the standard applied at important web sites or in charting software packages.
Constructing a P&F Chart
To start the chart, a trader has to make a decision about how large of a price change will be represented by each X or O. This is called the box size. In the chart above, a box size of $1 is used. Each X or O represents a $1 price change. Any price change below this value is ignored.
Although this chart uses a $1 box size, there are other settings that could be used. Many web sites use a box size based on the price of the stock. This is shown in the table below.
The second decision a trader needs to make when setting up a P&F chart is when to reverse columns, when to change from Xs to Os. This is called the reversal amount and is usually set to 3 boxes.
After defining the parameters, the following steps are completed every day to maintain the P&F chart.
When the current column is an X-Column (rising):
- Use the high when another X can be drawn and then ignore the low.
- Use the low when another X cannot be drawn and the low triggers a 3-box reversal.
- Ignore both when the high does not warrant another X and the low does not trigger a 3-box reversal.
When the current column is an O-Column (falling):
- Use the low when another O can be drawn and then ignore the high.
- Use the high when another O cannot be drawn and the high triggers a 3-box reversal.
- Ignore both when the low does not warrant another O and the high does not trigger a 3-box reversal.
Of course, these steps are completed automatically at popular web sites.
The Value of the P&F Chart
Because P&F charts ignore small price changes, they filter out the noise of the market and show the trend. Remember that on a P&F chart, a column of Xs shows the price is going up while Os are used when prices are falling. A chart using a 3 point reversal changes only after a three point move occurs.
The trend is obviously simple to spot. If the current price is atop a column of Xs, the direction of the trend is up. When the most recent column is a series of Os, the direction of the trend is down. The charts can also be used to generate buy and sell signals.
Buy and sell signals on P&F charts are very clear. The simplest signals are double top buys and double bottom sells.
A double top buy signal is given when a column of Xs rises above the top of the previous column of Xs. This shows prices have broken through short-term resistance. A double bottom sell signal is the opposite of a double top and occurs when a column of Os drops below the previous O column.
The next chart shows these two signals.
There are other signals but they are all variations of this theme. A breakout is the signal. If the breakout is indicated by an X, the chart is providing a buy signal. When the breakout involves an O, a P&F sell signal is given.
P&F charts provide clear and precise trading signals because they filter out the short term noise of the market action. Traders can immediately identify the direction of the trend with a glance at the chart. P&F charts can be combined with moving averages or other indicators to make trading decisions.
Other Uses of the P&F Chart
Price targets can also be developed from P&F charts. There are two general techniques for this, called the horizontal count and the vertical count. This technique has been added to chart of IWM in the figure shown below.
This is the pattern at the end of September. IWM has been in a trading range for months and now we have a price target indicating a gain of more than 30% is possible.
To find the target, we count the number of columns that form the trading range. In the chart above, we had a clear trading range from December 2016 until a buy signal was given in February 2017. That range included 20 columns.
We multiply the size of the range (20) by the reversal size used to create the chart (3, in this case) to find the size of the projected move. That provides a targeted move of $60 which is added to the breakout price where the buy signal was given to find a price target.
A less used technique is to count the number of Xs or Os that form the column that develops after the breakout occurs. This is then added to the top of the column for Xs or subtracted from the bottom of a columns of Os.
The vertical count assumes prices will move in line with the magnitude of the initial breakout. The horizontal count assumes prices will move in proportion to the amount of time spent in the trading range. Both techniques offer targets that should be considered imprecise, at best.
Right now, the P&F charts of all major market averages look similar to the appearance of the chart of IWM shown. They are all breaking out of trading ranges and all point to significantly higher price targets. This technique, for now, is bullish.
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