Point and Figure Charts : A Time-Tested Tool for Technical Analysis

In the dynamic world of financial markets, investors and traders constantly seek tools that can provide valuable insights into market trends and potential opportunities. One such tool that has stood the test of time is the Point and Figure (P&F) chart. Originating in the 19th century, P&F charts have evolved into a powerful technical analysis tool, admired for their simplicity and effectiveness in capturing price movements. This article delves into the world of Point and Figure charts, exploring their construction, interpretation, and the valuable insights they offer to market participants.

Construction of Point and Figure Charts

Point and Figure charts are distinctive in their structure, as they focus solely on price movements while ignoring the element of time. These charts consist of columns of Xs and Os, representing bullish and bearish price movements, respectively. The Xs and Os are plotted along the X-axis based on predefined price increments, known as the box size.

Below is an example of SBIN covering the period from May 22 to Dec 23. The point and figure chart has been drawn using 5-point boxes with a reversal size of 3 boxes. That means the direction in the chart will only change at 5X3 = 15 points. 

The box size determines the minimum price movement required to register a new X or O on the chart. Additionally, the reversal amount dictates how much price movement must occur in the opposite direction for a new column to form. This unique construction eliminates minor price fluctuations and noise, providing a clearer picture of significant trend changes.

The trading-view platform has the option to select a point and figure chart to work with. If you want to draw 45 degree lines as support or resistance on the point and figure chart created by trading-view, make sure that you "lock price to bar ratio" in the scale option under the settings. The lock price-to-bar ratio should be equal to box size. Here in the above chart it is set to "5". 

Usefulness of Point and Figure Charts

Clear Identification of Trends:

P&F charts excel in highlighting trends by eliminating unnecessary noise. The Xs and Os are arranged in columns, making it easy to identify whether the prevailing trend is bullish or bearish. This clarity is particularly useful for long-term investors seeking to align their strategies with the dominant market trend.

Support and Resistance Levels:

P&F charts are adept at identifying key support and resistance levels. Horizontal columns of Xs or Os create these levels, and when prices break through them, it can signal potential trend reversals or continuation. Traders often use these levels to set entry and exit points, adding a valuable layer to their decision-making process.

Price Targets and Patterns:

P&F charts can be instrumental in setting price targets. By measuring the vertical distance of a bullish or bearish column and applying it to the breakout point, traders can estimate potential price movements. Moreover, P&F charts can reveal various chart patterns, such as double tops, triple tops, and trendlines, aiding traders in making informed predictions about future price action.

Risk Management:

Risk management is a crucial aspect of trading, and P&F charts can assist in this area as well. The predefined box size and reversal amount allow traders to establish clear risk-reward ratios, enabling them to make more calculated decisions and manage their portfolios effectively.

Pullback - The three-point reversal method in point-and-figure charting

The three-point reversal method in point-and-figure charting is a technique used in stock market trading to identify potential trend reversals. This method focuses on patterns that form after a significant price movement. Here's a brief explanation of the three-point reversal method:

1. Initial Trend: The first step is to identify the prevailing trend. This can be an uptrend or a downtrend.

2. Reversal Signal: For an uptrend, a three-box reversal occurs when the price falls by a predetermined number of boxes (usually three) from the highest point. For a downtrend, a three-box reversal occurs when the price rises by the same predetermined number of boxes from the lowest point.

3. New Trend Confirmation: After the reversal signal, a new column of Xs or Os is drawn to confirm the reversal and indicate the beginning of a new trend.

As per AW Cohen, the profit percentage in trade can be increased by taking trade on pullbacks. The pullback trade example in AW Cohen's writing refers to triple top/bottom formation using the 3-point reversal method. Trading using a double top/bottom formation for pullback trading is not desirable.

The Rules for Pullback Trading

1. Triple or Multiple Top-Bottom Breakout: This rule suggests that a more significant pattern, such as a triple top or bottom, is preferable for a pullback trade. This may be seen as a stronger indication of a trend reversal compared to a double top or bottom.

2. Breakout of One to Three Boxes: The breakout from the pattern, when it occurs, should be relatively swift and occur within one to three boxes. This implies that the price should make a decisive move beyond the pattern, indicating potential strength in the new trend direction.

3. Pullback into the Pattern: After the initial breakout, the price should experience a pullback into the pattern. A pullback is a temporary reversal in the price movement, and in this case, it should be back into the area of the triple or multiple top-bottom breakout.

4. No Reverse Signal from the Pullback: During the pullback, there should not be any signals suggesting a reversal of the trend. This means that the pullback is seen as a temporary retracement rather than a complete reversal of the trend.

5. Price Turns Around and Breaks Previous Breakout Column: After the pullback, the price should reverse and break beyond the previous breakout column. This is the confirmation that the pullback was indeed a temporary retracement, and the trend is continuing in the direction of the initial breakout.

6. Counting method of point and figure chart may be used for setting potential target.