-figure signal isone of the more common modifications to the system, because it can limit risk to any leveland still maintain a logical stop-loss point, Of course, the smaller the risk, the fewer theopportunities and the more likely you will be stopped out. There are two approaches thatare recommended for entering on limited risk:
1. Wait for a.reversal back to within an acceptable risk, then buy or sell immediatelywith the normal point-and-figure stop. Figure 11-7 shows various levels of riskusing corn (a 5,000-bushel contract, with $50 for each 1¢ move). The initial buy sig-nal is at 258, with the simple sell signal for liquidation at 249, giving a risk of 9¢, or
 
FIGURE 11-6 Placement of stops.
Resistance
Stop—toss
Support
 
 
Bar chart Point—and—figureTRADING TECHNIQULs 265
 
 
FIGURE 11-7 Entering on a pullback.
 
x260 xa
x
258 9 .
oe =< Simple buy, risk 9¢ or $450256 0X0X
OOOH
~<——~ Risk 7¢ of $36024 0X 0X OXEEO
OxOX0Xx~<—— Risk 3¢ or $150
~<———— Risk S¢ or $250252
250 9 O0XxXO0X“OO Risk 1¢ oF $50 (support level)
Or Stop—loss at 249
 
$450 per contract. Wait for a reversal following the breakout, and buy when the lowfor the day penetrates the box corresponding to the predetermined risk. Buyinginto a declining market assumes that the support level will hold, preventing thestop-loss point from being reached. Because of this, the base of the formationshould be as broad as possible. The test of a triple bottom or a spread triple bottomafter a buy signal is a more reasonable place to go long than a simple buy after asmall reversal in the middle of a move.
It is not advisable to reduce risk by entering on the simple buy signal and. placing astop-loss at the point of the first reversal (3 boxes below the highs). The advantage of wait-ing for the pullback is that it uses the logical support level as a stop. A stop-loss placednearby following a breakout has no logical basis and will quickly result in a losing trade.
2. Enter the market on the second reversal back in the direction of the original sig-nal. As shown in Figure 11-8, the first reversal following a signal may not be withinthe desirable risk, but by placing a trailing entry order using the point-and-figure re-versal value, while prices are moving counter to the direction of the signal, an entrywill occur on a confirmation of the original direction witli a stop-loss at the mini-mum 4-box distance.
 
FIGURE 11-8 Entering on a confirmation of a new trend after a pullback,
Systern
Place your~<— buy orderhere
<g
xxxXKXOXx 0GxO
XOX:XOX:XO +
xx KKKeoa0eCK2000
Originalstop—loss
 
Placing your order Your new stop266 POINT-AND-FIGURE CHARTING
 
This technique.is frequently used by traders who firmly believe that a reversalfollows immediately after a breakout and prevents both high risk and false signals.If the pullback that follows the breakout continues in an adverse direction, pene-trates the other support or resistance level, and triggers the original system stop-loss, no entry occurs, thus saving a substantial whipsaw loss.
The reversal principle in step 2 can also be effective for building positions. In bar chart-ing, a pullback to a bullish support line or a bearish resistance line was a point for addingto a position with a risk limited to penetration of the major trendline. The equivalent pro-cedure using point-and-figure is to add on each reversal back in the direction of the trendusing the newly formed stop-loss point to exit the entire position as shown in Figure 11-9.
3. Allowing for irregular patterns. Price patterns are not always as orderly as we wantthem to be, and the price activity at time of a trend change can be very indecisive.One basic trading principle demands that the market confirms a new high beforebuying; the first new high. might simply be an erratic sideways pattern, or an ex-panding formation after a period of low volatility. If we require prices to make anewhigh by more than 1 box on the next upward thrust, and increase the minimum byanother box on the third upward thrust, we can actually demand that the momen-tum increase before a position is set.”
This technique, which tends to minimize false breakouts, may be modified toincrease the confirmation threshold from 2 to 3 or 4 boxes as market volatilityincreases. If the box size is changed according to volatility, as discussed later in thischapter, confirmation can remain at 2 boxes.
Take It and Run!
There comes a time in most substantial moves when there is ample profit and apprehen-sion about how much of the paper profit will be returned before the system close-out sig-nal is reached. Some traders prefer to take the profits. These are decisions that go beyondthe area of technical analysis. If the profit currently held in open positions is enough tosustain a life of leisure, a home in the mountains or South Seas, a country club, and a smallinvestment in a hotel or restaurant to occupy your time, then take it and run! A trading sys-_7 Adam Hewison, “The Will Rogers Theory of Point & Figure Trading,” Technical Analysis of Stocks & Commodi-ties (August 1991).
 
FIGURE I[-9 Three ways to compound positions.
 TRADING TECHNIQUES 267
 
tem should not depend on a single, very large profit, to work over time. It should have asuccessful, consistent profile. We can, therefore, reason that any extremely large profit is awindfall and should be taken.
If you cannot sleep nights because you need money to meet personal commitments,you have just the right amount in unrealized profits, and 1 or 2 adverse days would ruinthe opportunity, take the profits and begin again with a small investment. Technically, thatis an issue of investor risk preference. If you want a logical place to cash in on current openprofits but you have some time and latitude, as long as you do not lose more than 10 to25% of the existing profits, use the point-and-figure reversal value. The reversal value, thebox size times the number of boxes in a reversal (usually three), is meant to indicate a sig-nificant contrary move and can be used as an objective indication of a change of direction.One approach to taking profits is shown in Figure 11-10.
In Figure 11-10a, a trailing 3-box reversal value is used for the stop-loss once there isa sustained move of at least 10 boxes. To reenter the move in the same direction, the sametechnique is used (Figure 11-10), adding another 4 boxes of profits while keeping thenew risk small. In Figure 11-10c, this method lost 4 boxes of the potential profits when thereversal was short-lived. :
In general, taking small profits in this way does not improve profits, because it mostoften misses the biggest moves. It may, however, reduce the risk of loss at a rate even fasterthan the reduction in profits, yielding a better reward-to-risk ratio. A new rule should becarefully tested to know its effect on different market conditions. If successful, it shouldalways be used. Selective use is more likely to limit potential profits without reducinglosses. This topic is covered thoroughly in Chapter 21 (“Testing”).
Alternate Treatment of Reversals
Traditional point-and-figure charting favors the continuing trend. On highly volatile days, oroutside days, it is possible for both a trend continuation and a reversal to occur. Point-and-figure rules require that the trend continuation be recorded and the reversal ignored. Figure11-11 shows a comparison of the two choices. In the example, prices are in an uptrend whena new 1-box high and a 3-box reversal both occur on day 6. In Figure 11-118, the traditionalapproach is taken, resulting in a continuous upward trend with a stop-loss at 790. Taking thereversal first as an alternate rule, Figure 11-11c¢ shows the same trend with a stop-loss at 805.
 
FIGURE 11-10 Cashing in on profits.
 
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 268 POINT-AND-FIGURE CHARTINGeeaFIGURE IJ-I] Alternate methods of plotting point-and-figure reversals. (a) Sample pricesfor plotting. (b) Traditional method. (c) Alternate rule taken on day 6. 1
Day High Low
 
 
1 802790
2 Bll 795
3 813792
4 818 796
5 825 810
6 832 808
7 840 825
(a)840 x x835 X x830 x x825 x x x820 x x 0 X3815 x, x OX810 X x x x 0805° X O X x 0 X300 X OX. xX 0X795 X O x oO790 xX x(d) ' (9
 
Plotting the reversal first will usually work to the benefit of the trader; both the stop-loss and change of trend will occur sooner. Subsequent computer testing proved this to betrue. The alternate rule will not help when the reversal value is small and the optionalreversals, or outside days, occur frequently.
PRICE OBJECTIVES
Point-and-figure. charting has two unique methods for calculating price objectives: bori-zontal and vertical counts. These techniques do not eliminate the use of the standard barcharting objectives, such as support and resistance levels, which apply here as well.
x
The Horizontal Count
The time that prices spend in a consolidation area is considered important in determiningits potential move. One technique for calculating price objectives is to measure the widthof the consolidation (the number of columns) and project the same measurement up ordown as the target of the move. The point-and-figure horizontal count method is a moreexact approach to the same idea.
The upside price objective is calculated as
=P, + (WR) _where Hy is the upside horizontal count price objective -P, is the price of the lowest box of the baseW is the width of the bottom formation (number of columns)R is the reversal value (number of boxes times the value of one box)
To complete this formula, the base (width of the bottom or top formation) needs to be iden-tified. Count the number of columns, W/ not including the breakout column and multiplythat width by the value of a minimum reversal, X; then add that resuit to the bottom point ofthe base to get the upper price objective. The base can always be identified after the break-out has occurred. For example, Figure 11-12 shows the March 74 contact of London Cocoa 
FIGURE 11-12 Horizontal count price objectives.
20OOC
        
 
+ S000,g wre eee2 9900000Z wave Rein neog goekssssssbe8 Perr“3 gqcdssdsz£ 200000 lee3S JOKE ceBe s|S =ze aisg 332eon 2 sO2SfNEES‘goséa0 |RETR ew eaeoS00 |Sels xSP 1Bole o5c= RXRKK RK LS= 2 ‘Soenee$350aie“ 90000sexageegsoecoxeeEo26369eee eae‘9000558050 »x ETERSal ‘S000 °a OU 2 Co ol’Blo SSS8SSESS0 | 82 :Sz xxx = 8~ls so00 nx a SsEES RRR AKERg)8 8 ~els gas ; 3noe Pikea IOOOOOSOOCOS3 23 alg: zsa 090 | z15 I NO OEES3S00 oweer ee OE‘S50aS eeeeoco0ddsecaonegoSoSane ae ce~ o°oOPrcer- _ 20d85850eager De see :28350= weea wee”= wo 2006es0< RQ] SPRLs wagegs a ‘O00 ao: 3 “Sasso |"2 xeeee 1£ S50 -xTg z ‘So00 | *8 = 800? |8 0090065 =8 exK ~ a& 8 3a eetssgose gxan 2xene aoeooostSo2605S288oS 2 2 2 Q oO S So Q o o 2 Q ag@ 28 $s 3 §& 8 €$ 8 8 88 & §$ 8 & © & & & & ® = $ 8 8 8
269270° POINT-AND-FIGURE CHARTING
 
(£4 box) forming a very long-but clear base. The reversal value is £12, and the width of thebase is 19 columns (not counting the last column, which included the breakout). Added tothe lowest point of the base (£570) this gives an objective of £798, reached on the left shoul-der of the topping formation. Another alternative is the wider base, marked as W, = 25. Usingthis selection results in a price objective of £870, by adding 25 x £12 = £300 to £570, the low-est point of the base.
The downside objective is calculated in the same manner as the upside objective:
Hy = Pu — (WXR)where 4p is the downside horizontal count price objectivePy is the price of the highest box of the top formation
W is the width of the top formation (number of columns)R is the reversal value
Some examples are given for downside objectives in the same cocoa diagram (Figure11-12). A small correction top could be isolated at the £720 level and two possible topwidths, W; and W,, could be chosen. W3, the broader top, has a width of 9 and a downsideobjective of £632. W, has a smaller width of 5 and a downside objective of £680. Althoughthe lesser objective, calculated from Ws, is easy to reach, the farther one is reasonablebecause it coincides with a strong intermediate support level at about £640.
The very top formation was small and only produced a nearby price objective similarto the first downside example; there would be no indication that prices were ready for amajor reversal. The top also forms a clear head-and-shoulders pattern, which could beused in the same-manner as'in bar charting to find an objective. The height of the top ofthe head to the point on the neckline directly below is 20 boxes; the downside price objec-tive is 20 boxes below the point where the neckline was penetrated by the breakout of theright shoulder, at £776, giving £696 as an objective.
The horizontal count can also be applied to a breakout from a triangular formation,similar to the one on the very far right in Figure 11-12 (marked “Head-and-shoulders objec-tive”). The width of the formation, W, is the widest point in the center of the triangle, andthe upward objective is also measured from the center, rather than from the bottom of thetriangle. -
The Vertical Count
The vertical count is a simpler and more definitive calculation than the horizontal count,As with the horizontal count, there is adequate time to identify the formations and estab-lish a price objective before it is reached. The vertical count is a measure of volatility, theamount of rebound from a top or bottom, and can be used to determine the size of aretracement after a major price move. To calculate the upside vertical count price objec-tive, locate the first reversal column after a bottom. To do this, a bottom must be estab-lished with one or more tests or a major resistance line must be broken. The vertical countprice objective is then calculated: °
Vap = lowest box + (number of boxes in first reversal ~xX minimum number of boxes in a chart reversal)The downside vertical count price objective is just the opposite:Vaown = highest box — (number of boxes in the first reversalX minimum number of boxes in a chart reversal)
Examples illustrating the vertical count are easy to find. Consider the following cases:PRICE OBJECTIVES amee1. Acattle chart (Figure 11-13@) has an obvious bottom at 36.66 and a 13-box reversalimmediately following. Using the vertical count, a retracement of three times theprimary reversal (13 boxes) is added to the low of the bottom. The price objectiveis then 41.73, 39 boxes above the low.2. Following that upward move in cattle, there is a top of 43.42 followed by a down-ward column of 9 boxes. The price objective becomes 27 boxes below the high, or
 
FIGURE |J-13 (a) Cattle point-and-figure chart.
 
Cale {bor = £3 polo, 3 box reversal
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FIGURE 11-13 (Continued)-(b) Corn point-and-figure chart.
 
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\39.91, a likely goal on the chart because it is also the center of the only technical ad-justment during the downtrend.
3. Corn (Figure 11-134) topped at 312% and had an 11-box reversal in the next col-umn; the price objective is 33 boxes lower at 271%. Although that goal fell short ofthe lows by quite a distance, it netted about a 27¢ profit from the system sell signal.Earlier in the contract, there was an.intermediate bottom at 278% with a 6-box re-versal. The price objective of 301% was in the center of the prior major resistancelevel and resulted in another good trade.
As a simple measurement tool from contract highs or lows, this technique seems tohave some reliability once the bottom or top becomes clear. It is, however, far from perfect.o
A STUDY IN POINT-AND-FIGURE OPTIMIZATION
Throughout the point-and-figure discussion, there has been constant reference to rever-sal value or 3-box reversal, although there has been no explicit suggestion of any alterna-tive. In looking back at Table 11-1, it can be seen that the box sizes used prior to 1971were generally smaller than the 1975 box sizes. In addition, larger boxes are used forlong-term continuation charts and smaller ones for individual contracts of maximum termA STUDY IN POINT-ANU-FIGURE OPTIMIZATION 273Se eB1 to 1% years. These differences are due to changing price levels and volatility as Wyckoffhad suggested.
Prior to 1971, prices had been steadily increasing, but at a much slower rate than1974-1976. In a single year, the price fluctuation of any one market was easy to anticipate.Since 1969, prices have moved to unprecedented levels and back, with high volatility. Thestock market, represented by a wide range of indices, has continued to gain and expand indollar volatility throughout the early 1990s.
In 1969, sugar prices were plotted on a 5-point scale while prices ranged from 2.86¢to 3.95¢ per pound; the possible span of point-and-figure boxes that could be filled was22. In 1973, sugar prices went to almost 60¢ per pound, approximately 20 times their 1969price. The daily limits were expanded from “4¢ to 2¢—more than the price had moved in 1year. The use of a 5¢ point-and-figure box would result in a new reversal column on anyday the market failed to continue its prior direction, and it no longer served the functionof smoothing the price movement. It took 1,200 boxes (10 feet of graph paper) to recordthe moves all the way up to 60¢.
One reason why the sugar scale changed from 5¢ to 20¢ boxes or soybeans from 1¢ to10¢ was the practical need to fit the point-and-figure chart on a single page. Oddly enough,rescaling to fit a piece of paper of constant size has considerable merit. Look at soybeans in1970. The range of the January 71 futures contract was 251% to 315 and required a page ofgraph paper with only 64 boxes and an assigned value of 1¢ per box. Table 11-2a showswhat happens if the same number of boxes is used each year and if the scale is changed toaccommodate the full price range. The reversal value is forced to increase so that the size ofthe pointand-figure chart and formations will look the same regardless of the price level.This is called keeping the sensitivity constant. The point-and-figure method, with itsincreased reversal value due to larger box size, will generate about the same number ofreversals and buy and sell signals at any price level. Had prices increased without the boxsize increasing, the system would have had more frequent reversals, as in the sugar exam-ple, and it would be considered more sensitive to price changes. Table 11-2b shows thecomparable scaling for the S&P 500 from 1988 (after the “crash”) through 1996. During thisperiod, the stock index had an equal number of years with slightly higher volatility, as wellas years with as much as 50% lower volatility. During the quieter years there would havebeen very few trading signals.
The relationship of reversal value to the average price for soybeans from 1971 through1977, and the S&P from 1988 through 1996 gives a price-volatility relationship, shown inthe last column of Table 11-2a. It is important to know to what degree prices will fluctuateas they advance and decline. This can become a valuable risk management tool.
Before continuing, certain questions must be asked of this method:
Why were soybeans started with a 1¢ box... why not 4¢ or 5¢?_Does this price-volatility relationship represent the best approach to rescaling?How can it be used? -
It can only be assumed that the original selection ofa 1¢ box for soybeans was a com-bination of both a smoothing attempt (chosen as a multiple of the minimum move) andconvenience. The convenience part is easy to see; all the box sizes in Table 11-1 wereeven numbers. The first point-and-figure charts were drawn using the smallest allowablemove and later refined to larger increments to identify long-term trends, and major sup-port and resistance levels. However, it is necessary to find a more logical selection ofstarting parameters. »
‘To answer the second question, the impact of rescaling on trading must be considered:As prices rise, boxes become larger and the minimum risk becomes proportionately greater.274 POINT-AND-FIGURE CHARTING
 
neTABLE 11-2 Keeping the Size of the Chart the Same
(a) Soybeans ( January Futures Contract)
 
 
 
Reversal as
Total Percentage
Box Number Reversal of Average
Yeor High Low Average Size Reversal of Boxes Value %1971 315 251 283 1.00 3 64 3.00 1.061972 346 282 314 1.00 3 64 3,00 0.961973 444 300 372. 2.25 3 64 6.75 1.811974 OS 349 632 8.84 3 64 26.53 4.201975 961 509 735 7.06 3 64 2119 2.881976 705 439 572 446 3 64 12.47 2.181977 782 490 636 4.56 3 64 13.69 215(b) S&P 500 Futures (Continuous Daily Prices)
1986 250 205 228 0.70 3 64 211 0.931987 330 — 175 253 242 3 64 7.27 2,881988 280 240 260 0.63 “3 64 1.88 0.721989 350 280 315 1.09 3 64 3.28 1.041990 365 - 285 325 25 3 64 3.75 151991 410 310 360 1.56 3 64 4.69 1.301992 440 (390 415 0.78 “3 64 2.34 0.561993 470 425 448 0.70 3 64 21 0.471994 480 435 458 0.70 3 64 2.11 0.461995 610 460 535, 2.34 53 64 7.03 1.311996 745 600 673. 2.27 3 64 6.80 1.05
 
The risk of trading one contract increases at the same rate as the volatility expressed as a per-
centage of average price. If the box sizes are not increased when prices rise, risk can be kept
small, but frequent losses will occur and trading will be based on extremely short-term trends.There are few alternatives to rescaling, the two most reasonable being: ,
Method 1—Rechart at new price levels using larger box values to keep the size of thechart constant and the sensitivity fixed as shown in Table 11-2.
Method 2—Increase the box value at a rate based on a fixed percentage of the currentprice so that a chart with a box value of 3 points at a price of 300 (1% value) wouldhave a 6-point box at a price of 600. —_
Both approaches effectively increase the box value and risk while reducing the sensitiviryof the chart as prices increase. -
Solving the Scaling Problem
To avoid being arbitrary in selecting a price-volatility scdling relationship, we perform aregression analysis on the average price and box size to get a formula for the relationship.-A linear approximation was performed using the soybean values in Table 11-2a, based ona 3-box reversal, with the following results:
- 100 x volatility = -28.8 + .485 x average pricebox size = -3.347 + .0147 x price
The exact figures for the box size corresponding to specific price levels are shown in Table11-3. Understanding that box sizes must be in practical increments, a variable box point-A STUDY IN POINT-Aiw)-FIGURE OPTIMIZATION 275
 
and-figure chart can be constructed that changes box size as the price increases accordingto the table. These box sizes are shown with their corresponding price levels in Table 11-4.
Scaling by Constant Rate
The second choice of scaling requires answering the question: “Why were soybeans startedwith a 1¢ box?” The long-term charts show that prior to 1970, prices were relatively stableand fluctuated in normal ranges. Finding the proper box size for the initial interval formsthe basis for continuing into more volatile years. In the 1970 study by Thiel and Davis enti-tled Point and Figure Commodity Trading: A Computer Evaluation (Dunn & Hargitt), theyapproach the problem of variable box size and reversal value strictly scientifically. Theyproceeded to test a good sampling of commodity futures markets, varying both the boxsize and reversal value, and recorded the resulting profits or losses and the reliability of thecombination (percentage of profitable trades). For example, the January 66 soybean con-tract test results are presented in Table 11-5.
 
TABLE I1-3  Point-and-Figure Price-Volatility Relationship (Method 1) ©
 
Average price 250 300 350 400 450 500 550 600Percentage volatility 92 W17 140 165 189 214 240 262Box size 328 1.06 1.80 2.54 3.20 4.04 4.75 5.49Average price 650 700 750 800 850 900 950 1000Percentage volatility 286 34 335 359 383 408 432 456Box size 6.22 6.96 7.70 8.43 9.17 9.9) 10.65 11.38
TABLE 11-4 Point-and-