Tic-Tac-Toeing Your Way To Better Returns

By David Hunt AAA

Technical analysis often clouds the simple truth that profits are gained by buying low and selling high (going long) or selling high and buying low (going short). There is a variety of indicators, from simple moving averages to Elliot wave movements and pivot points, but they all have the same goal: creating expectations of market movements to improve upon the probability that profits will be made.

While any technical indicator will bring its own benefit, one of the oldest and most trusted indicators is the point-and-figure chart. The chart is made to better predict inter-day trends by eliminating the "noise" that stops out many traders. Constructing and maintaining one of these charts will not guarantee profits, but it will improve the probability that a trader will be buying and selling closer to the beginning of a trend. (For more on filtering out noise, read Trading Without Noise.)

Constructing a Point-and-Figure Chart
To build a point-and-figure chart, start with a piece of standard graph paper containing vertical and horizontal lines. With the paper in a horizontal position, start from the left side of the graph and enter the opening price roughly halfway up the page.

For example, if you are plotting EUR/USD and the current price is 1.4209, then this price will be the chart's starting point. Now move over one column to the right.

As the price fluctuates, place an X every time the price goes up three points and an O every time it goes down three. A row cannot be started unless there are three Xs, meaning each box size is equal to three points (the three-box strategy).

Each time you start a new column of Xs or Os, move over a column, up one row and start placing Xs or Os vertically within the column as the price moves.

Figure 1

What It Means and How to Use It
A point-and-figure chart plots day-to-day price movements without taking into consideration the passage of time. This type of chart is used to filter out non-significant price movements and enables the trader to easily determine critical support and resistance levels. The chart resembles a tic-tac-toe matrix of Xs and Os, but when analyzed, the chart gives a solid representation of trend. (Read about another way to measure support and resistance in Gauging Support And Resistance With Price By Volume.)

Whenever three Xs are plotted vertically up, it means the short-term trend is moving to the long side; whenever three Os are plotted vertically down, it means the short-term trend is moving to the short side.

If you are using point-and-figure charts within your technical analysis system, look to buy when there are three Xs and sell when there are three Os.

Figure 2

As the chart above indicates, the EUR/USD pair is in a generally upward trend with a decent amount of downward pull. The price starts out at 1.4305 and right away goes into a bullish action - combining for a total of five Xs, or 15 pips (3 pips per X).

Following the three-box strategy, a trader would go long after the third X, giving them a two-X profit (6 pips) before the trend reverses.

Again, after three Os have been calculated, the trader would go short on this position, allowing him or her to get a hold of a trend that goes six boxes (18 pips) before reversing at the price of 1.4290.

This strategy enables a trader to limit losses and capture short-term trends that have a high profit/loss risk ratio. (For a closer look at profit and loss, read The Myth Of Profit/Loss Ratios.)

How Far? How Long?
Once a trend has been realized, just how far will it extend and how long will the trend continue its path? While a point-and-figure chart can be used to identify support and resistance levels, it can also be used to predict length of a trend by comparing it to the length of the pattern's movement.

Count the number of columns over which a trend has formed and expect the vertical movement of the trend to equal (roughly) the same amount of columns it took to form the trend.

For example, say an upward trend has formed over eight columns. The vertical trend should be expected to extend about eight Xs, or 24 pips, disregarding the fluctuations. (For more on this topic, read Testing Point-And-Figure Patterns.)

When the Charts Work
A point-and-figure chart is a useful technical indicator for active traders because it can be used across all markets successfully.

In each market, it is crucial to execute the box's point size and reversal standards in terms of the particular market being traded. We examined the three-box strategy in this article, which is common in the forex market, but depending on a trader's appetite for risk and market trading, any box size could work. To maximize risk, use smaller box sizes to identify trends; to lower risk, use bigger box sizes.

As a note, stocks, because of their high volatility, may need more room to block out the noise than commodities.

A point-and-figure chart is designed to identify market trends and work within a trader's overall plan. By accurately predicating market activity - no matter what the market is - a trader can use a chart to place trades with confidence.

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