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Online Stock Trading - Point and Figure Charting
Part Two: Beyond The Basics

(RightLine) -- In Point and Figure Charting Part One we talked about the basic characteristics of point-and-figure charts: what they measure and how they're formed. We finished up with a discussion of trendline analysis, using bullish support and bearish resistance to help determine entry points. One of the nice things about those trends is that they're completely unambiguous . . . They're always at 45-degree angles!

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But when you take it down to the most fundamental level, stock movement is driven by only one thing: differences in supply and demand. When buying outstrips selling (or vice versa), an equity's price changes.

This isn't always the case with a bar chart, where connecting various highs or lows in a trend can be an inexact science. Bar chart patterns often pose the same problem, because stocks rarely form textbook examples of head & shoulders, ascending wedges, and so on.

One of the advantages of point-and-figure patterns is that, like those 45-degree trendlines, there is no ambiguity. These patterns have set-in-stone definitions that don't depend on a trader's individual interpretation.

Point-and-figure chart patterns take the form of buy signals and sell signals. As we covered in Point And Figure Charting Part 1, this form of charting is used to give traders insight into key inflection points in the supply/demand relationship. A buy signal is formed when the current column of demand (X) exceeds a previous column of X. Our trusty example stock, ZZZ, should help to illustrate the point.

43     X  <- double-top
42 X   X
41 X O X
40 X O X
39 X O X

These three columns show that ZZZ had sufficient demand to move up to 42, then gave a three-box reversal with a pullback to 39. A fresh wave of buying then pushed the stock beyond its previous high, to 43. This formed a "double-top" buy signal. The move is seen as a bullish development because current demand exceeded prior demand. A "double- bottom" sell signal is the double-top's bearish counterpart, and is formed when supply (O) falls below a previous column of O.

To put it in terms that should be more familiar to bar chartists, these signals represent moves beyond support or resistance. The significance of those support/resistance levels increases with the number of previous columns. A rising stock that moves above two previous columns of X produces a "triple-top" buy signal. "Triple-bottoms" are formed when a stock moves below two previous O columns, as shown below:

42 O X
41 O X O X
40 O X O X O
39 O X O X O
38 O   O   O
37         O  <- triple-bottom

The two prior columns of O that bottomed out at 38 represented support. A breakdown through that level would be seen as a negative development. As you might imagine, triple-tops and triple-bottoms tend to be more reliable than double-tops and double-bottoms. Occasionally you'll even see quadruple tops or bottoms (X or O exceeds three previous columns). These indicate that a very solid support/resistance level has been broken.

Okay, enough with the hypothetical examples...Let's check out some real-world chart patterns.

Affymetrix (AFFX) - Point and Figure chart:

Another type of pattern - the bullish or bearish triangle - denotes a move out of consolidation. These signals aren't all that common, but they often produce explosive results. A triangle is formed by a tightening range (lower highs and higher lows) for at least 5 columns. The pattern is neutral until the stock breaks out of the range, at which point a bullish triangle buy signal or bearish triangle sell signal is created.

Duke Energy (DUK) - Point and Figure chart:

- - Bullish Percent

Point-and-figure analysis also provides a tool to gauge risk/reward: Bullish Percent. But while trendlines and chart patterns can be helpful for shorter-term traders, the Bullish Percent method is more valuable to those with a longer timeframe. Market sentiment is measured by charting the percentage of stocks giving a buy signal within a given index or sector. Any reading over 70 is considered "overbought," while a reading below 30 is viewed as "oversold.

The prior mentioned chart patterns are not used with Bullish Percent charts. Instead, sell signals are given when the indicator moves above 70, then reverses 6% (creating a column of "O"). Buy signals are given when the percentage reverses 6% -creating a column of "X" - after dropping below 30.

From a contrarian standpoint, very extreme readings are also viewed as a sign that the market is due for a reversal. A powerful example occurred following the 9/11 attacks, when the NASDAQ-100 Bullish Percent bottomed out at 2. Out of the 100 index components, only 2 stocks were on buy signals! However, the overwhelming negative sentiment was soon replaced with a bargain-hunting mentality, and the index rallied sharply in the following months.

Well, that about wraps up our introduction to the world of X's and O's. These articles should provide a good starting point for p-n-f analysis, yet they're by no means comprehensive. Traders looking for more information on the subject will find Thomas Dorsey's "Point and Figure Charting" an exellent guide. The book offers a thorough in-depth discussion and gives some interesting statistics on the rates of success for various patterns.

P-n-f charts are formed by alternating columns of "X" (rising price) and "O" (falling price), with the price axis showing the extent of the movement. For example, a stock that rose from 30.00 to 33.00 would form a column that looked like this:

33 X
32 X
31 X
30 X
This column would continue until the stock (we'll call it ZZZ) produced what's referred to as a "three-box reversal." Each "box" is a price unit. For stocks trading at 20-100, the box size is one dollar. Box size decreases to 0.50 intervals in the 5-15 range, and is bumped up to 2.00 for equities trading above 100. This difference is visible on the Intel chart, with the price axis shrinking to 50-cent divisions below 20.00.

These varying box sizes take into account the relative impact of a stock's movement, depending on its price; a 2-dollar move is a lot more significant for a stock trading at 12.00, compared to one that's trading at 43.00.

Let's return to our example. ZZZ is trading between 20 and 100, so it'll take a reversal of 3 boxes (3 dollars) to create a column of O's. Subtracting 3 from the column's high (33), we see that ZZZ will have to hit 30 in order to form a three-box reversal. But momentum is on the bulls' side. Shares only pull back to 31.75, then rise to a new high of 34.15. This adds another "X" to the column:
34 X
33 X
32 X
31 X
30 X

Finally, a more meaningful sell-off takes place as the stock falls from its relative high of 34.15. At this point it would take a trade at or below 31.00 to mint a three-box reversal (34 - 3 = 31). ZZZ falls to 31.02, then pauses. At this point there is still no reversal - the actual price level (31.00) has to be traded first. Finally, there's another round of selling and shares hit an intraday low of 30.93. The p-n-f chart now shows ZZZ trading in a column of O's:

34 X
33 X O
32 X O
31 X O
30 X

The stock would remain in a column O's until it gave a three-box reversal to the upside. For example, a decline to 25.70 would extend the column all the way down to 26. (But not 25 - it would take a tick at or below 25.00 to accomplish that). ZZZ would then have to turn around and move back to 29.00 (26 + 3 = 29) in order to create another column of "X."

Another point to keep in mind is that opening and closing price data is not used in p-n-f charting. What matters is the intraday high or low. If either of these extremes adds to a column or creates a three-box reversal, appropriate changes are made to the p-n-f chart. Any other movement is ignored. This goes a long way towards filtering out the price movements that don't have a major impact on the supply/demand relationship.

We can identify key turning points in that relationship by using trendlines, which are familiar to most bar chartists. These trends always form a 45-degree angle, and are denoted by "+" signs.

Adobe Systems (ADBE) - Point and Figure chart:

P-n-f trends are formed differently, but don't let that confuse you; approach them just like would with a conventional bar chart trend. As shown on the ADBE chart, strong reversals can take place when a downtrending stock encounters bullish support.

The same is true of an uptrending stock when it meets bearish resistance. Violations of those levels are also significant. The red arrow points out the recent breakdown below support, which is a negative sign for ADBE.

These are just one way to profit from point-and-figure analysis. In "Point and Figure Charting Part II: Profiting From Patterns" we'll delve deeper and discuss buy/sell signals (which indicate key turning points in the all-important battle between supply and demand), charting of indexes, and a useful technique to help manage risk.

- Kent Barton