Point-and-figure (P&F) charts have been a part of the technician's toolbox for more than a century. They were used by Charles Dow in the late 1800s and Victor deVilliers published the first detailed explanation of this technique in 1933 in his book, "The Point & Figure Method of Anticipating Stock Price Movements". P&F charts track only price changes and ignore time. Proponents of this technique believe that focusing solely on price changes eliminates day-to-day market noise. By ignoring smaller movements, traders believe that it should be easier to identify significant support and resistance levels. In this article we'll introduce you to several popular P&F patterns that may be useful in identifying potential breakouts.

Using a Traditional Tool
The simplest trade signals on a P&F chart are double tops and double bottoms (Figure 1). A double top buy signal occurs when a column of Xs, which are used to note rising prices, exceeds the top of the previous X column. A double bottom sell signal is given when a column of Os, which show declining prices, falls one box below the previous O column. (For more on this pattern, see Analyzing Chart Patterns: Double Top And Double Bottom.)

Double Top Double Bottom
Figure 1

Only three columns are required to identify a double top or double bottom. These signals show only that the stock price has reached a higher high or lower low and that the momentum is likely to continue in the direction of the breakout. They are very useful for spotting the short-term trend and identifying stocks that have just broken out of a consolidation pattern.

Another nice feature of P&F charts is that stop-loss points are easily identified. In the case of the simple patterns we are talking about, a trader could place a stop order just below the price where the breakout occurred. If it is a false breakout, the stock will quickly return to the congestion zone, below the new high indicated by the double top or above the new low indicated by the double bottom. In either case, the loss is limited to only a few points.

The Triple Top/Bottom
A more complex buy signal is the triple top, in which a column of Xs rises above two previous X columns. This means that the bulls were unable to push the price above a certain price level on two separate occasions in the past and signals the momentum is strong.

On the other hand, the triple bottom sell signal results from a column of Os falling below two previous columns of Os (as seen in Figure 2). These patterns require at least five columns to form, and more columns in P&F patterns indicate larger price targets because the breakouts tends to be more dramatic.

Triple Top Buy Triple Bottom Sell

Figure 2

After one of the mentioned patterns signals a buy/sell sign, the next step is to determine a strategic price target. One common method for choosing a target is to multiply the number of columns within the congestion pattern and to multiply that number by the box size (the minimum price change that must occur for a given period before an X or O is added to the chart). For example, as you can see from the chart below, a trader can see that the pattern is six columns wide, and each box represents a move of 0.50. The $3 target for this move exceeds the risk by a factor of three to one, making this an attractive trade.

Figure 3: Double bottom and triple top signals

Figure 3 also demonstrates the application of P&F patterns as a trading strategy. A double bottom sell signal is given near $18. Traders could act on that signal by closing long positions, selling short, or buying put options. At a minimum, traders should consider closing long positions when the P&F chart is on a sell signal. This type of chart is designed to filter out market noise, and is expected to reliably show changes in the trend. A trader is someone seeking quick profits, and should be holding stocks that are in confirmed uptrends.

Short Selling to Profit
It is possible that aggressive traders would want to sell the stock short on this sell signal, which means selling a stock they do not own. To do this, the trader must use a margin account and face a great deal of risk. When opening a short position, traders hoping to profit from price declines borrow the stock before they can sell it. They will need to repay the stock at a later date, and are responsible for paying any dividends that the stock earns and a borrowing cost, which is similar to interest. If the price goes higher, short sellers need to buy the stock back to cover their losing positions. The potential loss of a short position is unlimited, while the gain is limited because a stock price can never go below zero. (To learn more, read When To Short A Stock and the Short Selling tutorial.)

Buying a Put Option
A more conservative strategy for profiting from sell signals is to a buy a put option on the stock. In this strategy, traders profit from price declines while enjoying the protection of limited risk because they can only lose the amount they spent to purchase the option.

P&F a Useful Tool
Any of these strategies would have been successful in the scenario shown in Figure 3 because the stock went straight down from the double bottom sell signal and fell more than 50% over the next month. The long-only trader would have sold about 10% from the highest price reached in the previous rally. The short seller and option buyer would have profited and taken short-term profits, but the question is when they would have closed their positions.

The P&F chart is especially useful for showing when the trend is changing. After the rapid decline, this stock entered a consolidation phase, which lasted more than four months. The chart shows congestion, marked by directionless trading. The first signal with follow-through is a bullish triple top signal. This signal is clearly marked in Figure 1 and occurs near a price of $9.50. This is a signal to the short trader to take profits and close the position.

The long-only trader would act on this signal and watch his position double in value fairly quickly. Options traders would buy calls on this stock and enjoy an even greater gain from the leverage inherent in options. (For more on this technique, see Point-and-Figure Charting.)

The Bottom Line
Experienced traders are aware that not all P&F signals will work out as well as the two in our example. In fact, experience will show that simple P&F patterns will work about half the time. A great feature of P&F analysis is that traders can easily use congestion zones that precede the signal to identify stop-loss points, and in this way limit their losses when the signal fails.

Traders relying solely on simple P&F signals, however, may be disappointed with their results. Experienced traders prefer the triple top buy signal, which often outperforms the market. Perhaps the best use for P&F charts is for traders to employ them as part of a trading strategy, for example assessing the overall trend from the most recent signal and accepting trades based on another indicator, such as an oscillator like the relative strength index (RSI).

Related Articles
  1. Term

    Understanding Short Covering

    Short covering is buying back borrowed securities to close an open short position.
  2. Chart Advisor

    ChartAdvisor for October 9 2015

    Weekly technical summary of the major U.S. indexes.
  3. Professionals

    Top Stocks to Short, Go Long On to Beat the Market

    A long/short portfolio can help weather a variety of market scenarios. Here's how to put one together.
  4. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  5. Chart Advisor

    ChartAdvisor for October 2 2015

    Weekly technical summary of the major U.S. indexes.
  6. Options & Futures

    Pick 401(k) Assets Like A Pro

    Professionals choose the options available to you in your plan, making your decisions easier.
  7. Technical Indicators

    Why MACD Divergence Is an Unreliable Signal

    MACD divergence is a popular method for predicting reversals, but unfortunately it isn't very accurate. Learn the weaknesses of indicator divergence.
  8. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  9. Chart Advisor

    Weakness In Biotech Will Likely Continue

    You can breathe easy with your biotech holdings--assuming you aren't counting on them to make you rich.
  10. Chart Advisor

    Expecting a Big Breakout In These 4 Stocks

    These stocks are tightly wound following big moves, and upon breakout more big moves could ensue.
  1. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  2. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  3. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  4. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  5. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  6. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  2. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  3. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  4. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  5. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  6. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!