Testing Point-and-Figure Patterns

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 19th century, and Victor deVilliers published the first detailed explanation of this technique in his 1933 book "The Point & Figure Method of Anticipating Stock Price Movements." 

Rather than tracking price-and-time action like line charts or candlesticks, which mark the degree of an asset's movement over set time periods, P&F charting instead uses vertical columns stacked with either X's or O's, where X's represent rising prices and O's falling prices. 

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. Traders believe that by ignoring smaller movements, 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.

Double Tops and Double Bottoms

The simplest trade signals on a P&F chart are double tops and double bottoms. A double-top buy signal occurs when a column of Xs—which are used to show rising prices—exceeds the top of the previous X column. A double-bottom sell signal is given when a column of Os—which shows declining prices—falls one box below the previous O column.

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. Point and Figure charts are very useful for spotting the trend and identifying stocks that have broken out of a consolidation pattern.

Another nice feature of P&F charts is that stop-loss levels are easily identified. In the case of the double top and double bottom patterns, 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. On the third try, the bulls succeed in pushing price past the resistance formed by the highs of the prior Xs.

On the other hand, the triple-bottom sell signal results from a column of Os falling below two previous columns of Os, shown below. 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.

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 shown in 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.

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.

The Bottom Line

Experienced traders are aware that P&F signals will not always work. There are many times P&F signals will reverse. 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 see when signals fail and take action.

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, or RSI.