Point and figure charts

What Are Point and Figure Charts?

Point and figure charts are a type of charting method used in technical analysis that plots price movements based solely on significant price changes, rather than time. Unlike traditional charts that plot price against specific time intervals (e.g., daily, weekly), point and figure charts filter out minor price fluctuations, focusing instead on substantial shifts in price action. They are constructed using columns of X's and O's, where X's represent rising prices and O's represent falling prices. This unique construction aims to reveal underlying supply and demand dynamics and clear market trends by removing the element of time and insignificant "noise" from the chart.

History and Origin

The concept behind point and figure charts dates back over a century, emerging in the late 19th century as a method for market participants to manually record and analyze price movements. One of the earliest known references appeared in an anonymous pamphlet titled "The Game in Wall Street and How to Successfully Play It" by "Hoyle" in 1898.⁴ Initially, these charts were simply called "figure charts" and used numbers to track price changes. Over time, they evolved to incorporate X's and O's. A.W. Cohen is widely credited with popularizing the modern "3-box reversal" point and figure chart method in the 1940s through his books and the Chartcraft publishing company.³ The manual nature of these charts made them particularly useful before the advent of widespread computerization, allowing analysts to efficiently track numerous securities.

Key Takeaways

• Point and figure charts focus exclusively on price movements, filtering out time and minor price fluctuations.
• They use columns of X's (for rising prices) and O's (for falling prices) to identify significant shifts.
• The charts help in clearly identifying support and resistance levels and discerning underlying chart patterns.
• A user-defined "box size" determines the minimum price movement recorded, and a "reversal amount" dictates when a new column of X's or O's begins.
• They are particularly useful for long-term trend analysis and identifying potential entry and exit points.

Formula and Calculation

Point and figure charts do not rely on a complex mathematical formula in the traditional sense, but rather on two key parameters that dictate their construction: the box size and the reversal amount.

The box size (B) represents the minimum price increment that must be exceeded to add a new X or O to the chart. For example, if the box size is set to $1, any price movement less than $1 is ignored.

The reversal amount (R) is the number of boxes the price must reverse against the current column's direction to trigger a new column. For example, if the reversal amount is 3, the price must move three box sizes in the opposite direction to initiate a new column of X's or O's.

There are different methods for determining the box size and reversal amount²:

• Traditional Method: Uses a fixed, user-defined box size and reversal amount.
• Percentage Method: The box size is a user-defined percentage of the current price, making the chart's sensitivity adjust with price level.
• Average True Range (ATR) Method: The box size is based on a multiple of the Average True Range indicator, which filters out typical market volatility.

Interpreting the Point and Figure Chart

Interpreting a point and figure chart primarily involves identifying distinct patterns and formations that signal potential shifts in supply and demand. Unlike time-based charts, the absence of time on the horizontal axis means columns can represent vastly different periods, depending on price activity.

Key interpretations include:

• Columns of X's and O's: A rising column of X's indicates increasing demand and an uptrend, while a falling column of O's signals increasing supply and a downtrend.
• Support and Resistance Levels: Horizontal lines where price repeatedly reverses, forming clear ceilings (resistance) and floors (support). These levels are often more pronounced and easier to identify on point and figure charts due to the filtering of minor movements.
• Trend Lines: Diagonal lines drawn to connect key X's or O's, indicating the prevailing direction of the asset's movement. A 45-degree trend line is common.
• Reversal Patterns: Specific formations of X's and O's that suggest a change in the prevailing trend, such as double tops, triple bottoms, or various spread patterns. These patterns can serve as potential buy or sell signals for a trading strategy.

The simplicity of these charts allows traders to focus on significant price changes, making it easier to spot these underlying structures and patterns.

Hypothetical Example

Consider a hypothetical stock, "DiversiCorp," currently trading at $50. We decide to create a point and figure chart with a box size of $1 and a reversal amount of 3.

1. Initial Plot: The first X is plotted at $50.
2. Uptrend:
   • If DiversiCorp's price moves to $51, another X is plotted above $50.
   • If it moves to $52, another X is plotted above $51.
   • If it moves to $53, another X is plotted above $52. (Column of X's: $50, $51, $52, $53)
3. No Change: If the price then oscillates between $51 and $53, no new X's or O's are added, as it hasn't moved a full box size in the current direction or reversed by the reversal amount.
4. Reversal:
   • Suppose the price then drops. For a reversal to occur and a new column of O's to begin, the price must drop by $3 (3 times the $1 box size) from the highest X.
   • If the last X was at $53, a drop to $50 ($53 - $3) would trigger a new column of O's. The first O would be plotted at $50, in a new column to the right of the previous X column.
   • If the price continues to drop to $49 and then $48, O's would be plotted consecutively downwards in this new column.

This process continues, forming alternating columns of X's and O's that clearly illustrate significant upward or downward price swings and periods of consolidation, stripped of minor fluctuations.

Practical Applications

Point and figure charts are employed by investors and traders in various practical ways to analyze market behavior and inform decision-making. Their primary application lies in filtering market noise and highlighting significant price movements, which can be particularly useful for identifying robust market trends and potential turning points.

Practitioners use point and figure charts to:

• Identify Trend Strength: Long, uninterrupted columns of X's or O's indicate strong trends, while frequent, short columns suggest consolidation or a lack of clear direction.
• Set Price Targets: Various chart patterns within point and figure charts, such as horizontal counts, can be used to project potential future price targets, offering insights for investment decisions.
• Generate Trading Signals: Specific bullish and bearish patterns, like "double tops" or "triple bottoms," often serve as signals for initiating or exiting positions. The Investopedia article "Point and Figure Charting: A Basic Introduction" highlights their utility in determining "solid entry and exit points in stock market trading."
• Manage Risk: By clearly showing levels of support and resistance, these charts can help in setting stop-loss orders and managing risk management strategies.

The clear visual representation of supply and demand imbalances, devoid of time, allows for a focused analysis of the underlying forces driving price. More detailed explanations of their construction and use can be found on financial education platforms.¹

Limitations and Criticisms

While point and figure charts offer unique insights into price action, they also come with limitations and criticisms, primarily stemming from their non-time-based nature and the subjective element in their construction.

One of the main criticisms is the lack of a time axis. Since the charts only advance when a specified price change occurs, periods of low volume or sideways movement, which might be significant in time-based analysis, are compressed or entirely absent. This can sometimes obscure how long a certain price level has been maintained or how quickly a move occurred.

Another limitation is the subjectivity in setting parameters. The choice of box size and reversal amount significantly influences the chart's appearance and the signals it generates. Different settings can lead to different interpretations and trading signals, making consistency across analyses challenging without a predefined methodology. This subjectivity can be a point of contention for analysts seeking more objective tools.

From an academic perspective, like many forms of technical analysis, point and figure charts face skepticism from proponents of the efficient market hypothesis (EMH). The EMH suggests that all available information is already reflected in asset prices, making it impossible to consistently achieve abnormal returns by analyzing past price data. [Accessed via Bogleheads.org] This academic viewpoint fundamentally questions the predictive power of such charting methods, implying that any patterns observed are merely random occurrences.

Point and Figure Charts vs. Candlestick Charts

Point and figure charts and candlestick charts are both visual tools for financial market analysis, but they differ fundamentally in their construction and the information they prioritize.

The main point of confusion often arises because both are charting methods, but their underlying philosophies differ. Point and figure charts distill price action to its essence, ignoring time, while candlestick charts provide a detailed, time-bound snapshot of price behavior. Analysts choose between them based on whether their primary focus is on filtering noise and identifying long-term trends or on capturing precise, time-sensitive market sentiment.

FAQs

What is the primary advantage of point and figure charts?

The primary advantage of point and figure charts is their ability to filter out insignificant price movements and market "noise," allowing analysts to focus solely on substantial changes in price and easily identify significant support and resistance levels and clear trends.

Can point and figure charts predict future prices?

No chart, including point and figure charts, can guarantee or predict future prices. They are analytical tools that help identify patterns and trends based on historical price data, which can inform potential future price movements and assist in developing a trading strategy.

Are point and figure charts better for long-term or short-term analysis?

Point and figure charts are often considered more suitable for long-term analysis due to their noise-filtering capabilities. They are effective at revealing significant underlying trends that might be obscured by day-to-day volatility on time-based charts, though they can be adapted for shorter timeframes by adjusting the box size and reversal amount.

Do point and figure charts consider trading volume?

Traditional point and figure charts do not directly incorporate volume into their visual construction. They focus exclusively on price changes. However, volume analysis can be used as a supplementary tool alongside point and figure charts to confirm the strength of price movements or patterns.