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How does point and figure analysis work?

The usual way to view chare price charts on a daily basis is to use a visual representation of the open, high, low, close and volume. This can take the form of a bar or candlestick chart, and there are variations such as area or line charts.

Certain technical analysts however prefer to examine point & figure (P&F) charts, and this technique was actually in use long before the advent of computerised charting techniques.

The basic difference with a P&F chart is that the axis of time is eliminated, and the analyst concentrates purely on price action and support/resistance levels. P&F charting analysis can be used in stock trading, forex and commodities.

The advantages of P&F charts

P&F charts can reduce or remove much of the short term ‘noise’ from charts.

They concentrate on price movements rather than the effect of time on a share.

The analysis of support and resistance levels is much simpler, and breakouts are easy to spot.

The analysis of trend lines is different but also very simple.

Long term big picture analysis is condensed and often easier.

Viewing a P&F chart

The P&F chart comprises a series of columns of X's and O's that represent price movements over time, and most stock trading software systems enable easy switching between the various types of charts.

Dates are actually shown on the X-axis of a P&F chart, but these are entered simply to denote times when there is a trend change, so time analysis is not linear.

On a P&F chart, rising prices are denoted by a column of X's and falling prices by a column of O's, which at its basic level means that where the last mark is an X, the trend is up, and it is down for an O.

Each X or O occupies a box on the chart, and this box size is pre-set on the chart. The box represents the amount by which a share price must move above the top of the current X column or below the bottom of the current O column before another X or O is added to that column.

The chart is also pre-set with another figure called the Reversal Amount and this determines the amount that a stock needs to move in the opposite direction (down in an X column, and up in an O column before a reversal occurs.

Once the reversal level is crossed, a new and opposing column begins to the side of the previous one, but in the opposite direction to represent a trend change.

The idea is that if a stock is in a clear trend, then that trend only reverses when the price moves beyond the reversal distance (box size multiplied by reversal amount) – otherwise the trend remains intact.

There are various settings for box sizes and reversal amounts, but most CFD traders experiment with the various default settings on each piece of software until they are comfortable with how much ‘noise’ they wish to filter out.

Summary of the rules

P&F boxes do not represent a single value, but a range of prices equal to and within the box size.

Where there is an ‘X', this represents increasing prices or demand, and ‘O's represent decreasing prices or supply.

There can only be X's or Os in any column, and never both.

Simple P&F Chart Patterns

Just like with bar and candlestick charts, chart patterns can be observed although trend lines are not time based, but are still valid. It should be noted that trend lines always appear at 45 degree angles, as there cannot be more than one reversal box to make the trend ‘steeper’.

P&F charts are very useful for identifying support and resistance levels. A support level is an area that prices may have bounced from previously, or a resistance area that was penetrated and now becomes support. Support levels on P&F charts are easy to observe by a historical row of Os at the bottom of various columns.

Resistance levels are also horizontal lines and represent an area where selling is expected to occur, and here they are at the top of a horizontal row of Xs. This makes it easy to spot what is know as a P&F breakout.

Breakouts and volume

P&F breakouts are often used as a simple trend trading technique, and it is much easier to scan the market for breakout on P&Fs than any other method. That said, the amount of the box size and reversal amount is important, as it is possible to miss the first part of a new trending move in the desire to filter out ‘noise’.

Whenever there is a P&F breakout, confirmation of underlying volume support in the same direction should be sought, although as always volume analysis always come second to underlying price action.

Mike Estrey
Head of Research at Blue Index, specialists in trading Contracts For Difference
19/12/2007

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