will be determinedby the method.
‘The rules for plotting point-and-figure charts are easily shown as a flowchart (Figure11-2). Preference is given to price movements that continue in the direction of the currenttrend. Therefore, if the trend is up (represented by a column of Xs), the new high price istested first; if the trend is down, the low price is of greatest importance. The opposite priceis checked only if the new price fails to increase the length of the column showing the cur-
rent trend.
 
SS EeeFIGURE [1-1 Point-and-figure chart.
- Silver
 
 
 
Lit i
 
 
 
x [x }>< J<Oj\O|oO
 
 
 
O}O]O}/O|O}O
 
 
 
 
 
 
 
 
 
 
 
  
 
Momentum and Oscillators
price levels. Among technicians, momentum establishes the speed of price move-
ment and the rate of ascent or descent. Analysts use momentum interchangeablywith slope, a straight-line angle of inclination of price movement as measured from a hor-izontal line representing time. Momentum is also thought of as force or impact; it is oftenconsidered, ‘as in Newton’s Law, that once started prices tend to remain in motion in asomewhat straight line.
Rate-of-change indicators, such as momentum and oscillators, are used as leading indi-cators of price change. They can identify when the current trend is no longer maintainingits same level of strength. This gives the trader an opportunity to begin liquidating theopen-trend trades before’ prices actually reverse. As the time period for the momentumcalculation shortens, this technique of leading a trend changes to become more aggressiveand is interpreted as a countertrend method. Use of a rate-of-change indicator anticipateschange even sooner.
Before beginning a discussion of various momentum calculations, a brief comment onterminology will be helpful to understand how various techniques are grouped together.We begin with a single price, which has no movement. When we talk about bonds at 110or gold at $400 per ounce, we are relating a price level and not implying that prices aregoing up or down. Next, we describe the speed at which prices are rising or falling. It is notenough to say that the S&P rose 3 points; rather, you must specify the time interval overwhich this happened “The S&P rose 3 points in one hour.” When you say that you droveyour car at 60, you really imply that you were going 60 miles per hour, or 60 kilometers perhour. This description of speed, or distance covered over time, is the same informationthat is given by a single momentum value.
The last measure is one of change in speed, which is either acceleration or decelera-tion. The price of the Deutschemark may have risen by .0150 dollars per mark in the pastweek, indicating an average speed of .0150/5, or a rise of .0030 dollars/mark per day; how-ever, it started rising slowly and increasing its speed over the week. Perhaps the mark rose-0010 on Monday, .0020 on Tuesday, .0030 on Wednesday, .0040 on Thursday, and .0050on Friday, increasing in speed (or accelerating) by .0010 each day. The term rate of change(ROC) will also be used to describe acceleration; when the rate of change is zero, we aretalking about speed and momentum.
You will see in this chapter that speed-is a more sensitive measurement than pricelevel, and acceleration is more sensitive than speed-The various techniques described hereare presented in order of speed and then rate of change. Following that is divergence, themost popular use of momentum indicators.
T:: study of momentum and oscillators is an analysis of price changes rather than
MOMENTUM
Momentum is the difference between.two prices taken over a fixed interval. It is anotherword for speed, the distance covered over time. For-example, today’s 5-day momentumvalue M would be the difference between today’s price P, and the price 5 days ago:
MOMENTUM
(6-day) M=P,-P,-sUsing notation familiar to many programmers:momentum = price ~ price(5]ormomentum = price - price(N}
where the notation [N] refers to the (closing) price N days ago.
‘The momentum value M, increases as the change in price increases over the 5-day
eriod. Figure 6-1 shows that momentum is also related to slope; that is, a faster price
increase will cause both angle @ to become larger and the hypotenuse of the triangle,
ked “momentum,” to increase. If the 5-day momentum is 100, the slope of the momen-
m line can be expressed as 100/5 = 20. If prices had increased by 150 points over thesame time interval, the slope would be 150/5 = 30 and the momentum would be 150.
‘The 5-day momentum M, can range in value from the maximum upward move to themaximum downward move that the price can make in 5 days; the momentum is zero ifprices are unchanged after 5 days. Figure 6-2 shows the possible moves in the momentumcalculation. Consider a commodity with a 20-point daily limit. Starting at point A, the 5-dayprice change increased at a faster rate for 8 days (up 2, up 4, etc.) until at point B, priceswere moving at their fastest 5-day rate. At point B the 5-day price change was three-fifths ofthe maximum 100-point change, or 60 points. From point B to point C prices stilincreased, but at a slower rate, until the 5-day difference at point C was zero. Prices thendeclined at an increasing rate until at point D the maximum 5-day decline of 40 points wasreached; at point E the 5-day difference was again zero. Note that at point B prices did notstart down but only increased at a slower rate; only at C did prices first begin their 5-daydecline.
Momentum as a Percentage
ther than a rawMomentum, as most other calculations, can be expressed as a percentage raul ivalue of its components. This is usually done by dividing the current value by the previousprice or index level, so that a 5-day momentum may be
 
Pi-Pies P= Pi-sSS oor
Pra Pros
 
———_—_ SSSFIGURE 6-1 Geometric representation of momentum.
    
PRICE INCREASE
ELAPSED DAYS
— ee 
a8 POINT-AND-FIGURE CHARTING
 
FIGURE 11-2 Point-and-figute daily rules.
\/
Get the high and towprices for today.
 
 
 
 
          
Ts the current columnXs_or Os?
Ts today's high at least 1 boxhigher than previous high?
   
    
Is today’s low at least 1 boxtower than previcus low?
 
Enter new XsDo not fill box ifscale price is greaterthan today’s high
                
Enter new Os.Do not fill box ifscale price is lessthan today’s low.
 
 
 
 
    
 
Today's high at3 boxes abovethe fowestcontaining an
least 3 boxes belowthe highest 6:containing an
   
 
   
 
Move right one column.Record today’s date. Enter Osianing 1 box below th
Move right one column.Record today's date. Enter Xsbeginning 1 box above thelowest box containing an “0”.Do not fill box if scale priceis greater than today's high.
(om) =) ‘
 
    
 
is less than today's low.
 
 
 
 
 
The traditional point-and-figure method calls for the use of a 3-box reversal; that is,the price must reverse direction by an amount equal to 3 boxes from the most extreme boxof the last column before a new column can-begin (it actually must fill the 4th box sincethe extreme box is left blank). The importance of keeping the 3-box reversal has long beenquestioned by experienced point-and-figure traders. It should be noted that the netrener.sal amount (the box size times the number of boxes in the réversal) is the critical value. Forexample, a $4 box for gold with a 3-box reversal means that gold must reverse by $22 toindicate a trend change. The opposite combination, a $3 box and a 4-box reversal, wouldactually signal a reversal of trend at the same time. The prop selection is based on thesubsequent sensitivity of the box size following the reversal. Therefore, a smaller box sizemay interpret the smallest price movements as a continuation of the trend and nltimatelycapture more of the price move; it is considered the preferable alternative. The choice ofbox size and reversal boxes will be considered later in more detail.
 
CHART FORMATIONS | - 259
CHART FORMATIONS
It would be impossible for the average speculator to follow the original method of recordingevery change in price. When applied to stocks, those charts became so lengthy that interpre-tations similar to those used for the traditional bar chart were necessary to select the best pat-terns. tn 1969, Robert E. Davis published Profit and Profitability, a pointand-figure studythat detailed eight unique buy and sell signals. The study covered two stocks for the years1914-1964, and 1,100 stocks for 1954-1964. The intention was to find specific bull and bearpatterns that were more reliable than others. The best buy signal was an ascending triple top,ved the best sell signal was the breakout of a triple bottom (Figures 11-3 and 11-4).
Plotted daily, futures prices do not offer the variety of formations available in the stockmarket. The smal} number of markets and the high correlation of movement betweenmnany of the delivery months make the limitations of signal selection impractical. Instead,the most basic approach is used, in which a buy signal occurs when an X in the current column is 1 box above the highest X in the last column of Xs, and the simple sell signal is anO plotted below the lowest O of the last descending column. The variability in the systemlies in the size of the box; the smaller the size, the more sensitive the chart will be to pricemoves. 191933, Wyckoff noted that it was advisable to use a chart with a different box sizewhen the price of the stock varied substantially.*
Trendlines
‘The bullish and bearish trendlines important to bar charting also exist for pointand-figurecharts, The top or bottom box that remains blank when a reversal occurs often forms thebeginning of a descending or ascending pattern at a 45° angle (diagonally through theboxes, providing the graph paper has square boxes). These 45° lines represent the majoranticipated trends of the marker. Once a top or bottom has been identified, a 45° line canhe drewn down from the upper corner of the top boxes of Xs toward the right, of up fromthe bottom of the lowest box of Os toward the right (Figure 11-5). These trendlines areused to confirm the direction of price movement and often filter the basic point-and-figuretrading signals so that only long positions are taken when the 45° trendline is up and onlyshorts are entered when the trendline is down.
Point-and-Figure StudiesIn 1970, Charles C. Thiel, Jr., with Robert E, Davis, completed the first purely funures marketpointand-figure study® that calculated profitability of a reasonably large sample of markets
2 Richard D. Wyckoff, Stock Market Technique, Number One (Miyckoff, New York, 1933, p- 89).3 Charles Thiel and RE. Davis, Point and Figure Commodity Trading: & Computer Evaluation (Dunn & Hargitt,‘West Lafayette, IN, 1970).
FIGURE 11-3 Best formations from Davis's study,
 
Ascending Triple Top Breakout of a Triple BottomX -— BUY x XxXx xX OxaxoX XOX OxOxoXOXOX o 0 0XOXO - O-—SELL
eee 
260
POINT-AND-FIGURE CHARTING
 
eeeFIGURE 11-4 (a) Compound point-and-figure buy signals. (b) Compound point-and-figure sell
signals.
1
 
 
 
‘Spread wiple top
 
 
Upside breakout of @symmetric triangle
 
 
 
 
 
<—Breakout
Ox Notanew low
 
‘Upside breakout of @bearish resistance line
‘Upside breakout of an
‘ascending wiangle *
(a)
Bullish eatapuit
 
 
 
 
 
symmetric triangle
 
bearish support
 
 
 
 
 
 
 
—<— Breakout
 
 
‘Downside breakout of 2bullish support ine
Dewntide breakout of @
escending triangle
(b)
Bearish catapult
 
 
POINT-AND-FIGURE BOX SIZE 261
 
—_— eee
FIGURE I1-5 Point-and-figure trendlines.
 
 
xxx xx
by varying both the value of a box and the reversal criteria (the number of boxes necessary tostart a new column). With the standard 3-box reversal and only simple buy and sell forma-tions, the tests showed 799 signals, of which 53% were profitable; the average net profit onall trades was $311 realized in approximately 50 days. The period studied was 1960 through1969. In the mid-1970s, Zieg and Kaufman performed a computerized study using the samerales but limiting the test period to 6 months ending May 1974, an extremely active marketperiod. For the 22 commodities tested, 375 signals showed 40% of the trades were prof-itable; the net profit over all the trades was $306 and the average duration was 12.4 days. Itis interesting to note that the most significant difference in the results of the two studies is inthe average length of a trade, from 50 to 12.4 days, indicating a change apparently inducedby more volatile markets. Although the two tests varied in many of the details, the results area strong argument for the consistency of the pointand-figure method as a trading tool.
In its current role, point-and-figure differs from other forms of charting because it pro-vides a rigid set of rules for entering long and short positions. Many of the formations are stillsubjected to interpretation and are frequently used in the original sense by floor traders; butas a tool for the speculator without access to intraday prices and the experience to under-stand the subtleties of chart analysis; point-and-figure fills an important gap. It will tell thetrader exactly what penetration ofa resistance or support level is necessary to generate a buyor sell signal and exactly where the stop-loss order should be placed to limit risk. It is thiswell-defined nature of point-and-figure charting that allows computer testing and evaluation.
The basic study of the point-and-figure method involves rules of charting, buy and sellsignals, trendlines, geometric formations, and price objectives. Since these points have beencovered effectively in at least two books currently available,’ they will not be repeated here.More advanced point-and-figure topics will be discussed, including its relationship to barcharting, alternate plotting rules, risk-limited trading, and varying box size.
POINT-AND-FIGURE BOX SIZE
‘The box size used in a point-and-figure chart determines the sensitivity, or frequency of sig-nals, and allows the identification of wends and wading ranges of various duration. Formany years Chartcraft was the only major service that produced a full set of point-and-figure charts (see Table 11-1).
4 Kermit C. Zieg, Jr, and Perry J. Kaufman, Point and Figure Commodity Trading Techniques (Investors Intelli-gence, Larchmont, NY, 1975). This book contains complete tabularized results of both point-and-figure tests,
3 AW, Cohen, How to Use the Three-Point Reversal Method of Point and Figure Stock Market Trading (Chartcraft,Larchmont, NY, 1972), and Zieg and Kaufman, Point and Figure Commodity Trading Techniques (1975).Cocoa? 1964 20 pts 106 pes 100 pes 50 pts 10 ptsCoffee (20) pts 100 pts 100 pts 50 pts 100 pesCotton (20) pts 100 pts 100 prs 50 pts._ Lumber (100) pts 100 pes $00 pts 100 ptsOrange juice 1968 20 pts 20 pts 100 pts 100 pesSugar 1965 5 pts 20 pts 20 pts 20 pts 10 prs =Metals
Aluminum - 50 ptsCopper . 1964 20 pts 100 pts 100 prs 50 pts 50 ptsGold 50 pts 100 pts 400 ptsPalladium - 100 ptsPlatinum 1968 200 pts 100 pts 200 pts 200 pts . 400 pts
262 POINT-AND-FIGURE CHARTING
 
ee
TABLE I!-la_ Point-and-Figure Box Sizes*
 
 
 
Prior to1975+ 1975+ 1977 19778 1986+Box Box Box Box BoxCommodity Year Size Size Size Size SizeGrains !iCorn 1971 Ae 2¢ 2¢ 2¢ Ig iOats 1965 Wg Ig \¢ IgSoybeans 1971 l¢ log log 5¢ 5¢ :Soybean meal 1964 50 pts 500 prs 500 pts 100 pts iSoybean oil 1965 10 pts 20 pts 20 pts 10 pts ;Wheat 1964 \¢ 2¢ 2 2¢ l¢ !Livestock and Meats |Cattle : 1967. 20 pts 20 pts 20 pts 20 pts !Hogs 1968 20 pts 20 pts 20 pts 20 prs }Pork bellies 1965 20 pts 20 pts 20 pts 20 pts |
                              
Other Agricultural Products
 
 
 
r 1971 100 pts 200 pts 200 pes 400 pts 1000 pts“a EEE
* All box sizes use a 3-box reversal and are in points (decimal fractions treated as whole numbers) unless otherwise Indicated.* Cohen (1972); parentheses indicate approximace values.
+ Courtesy of Charteraft Commodity Service, Charteraft,nc., Larchmont, NY.
§ Chare Analysis Limited, Bishopgate, London. Values are for long-term continuation charts.
1 Cocoa contract changed from cents/pound to dollars/ton,
Over.the past 10 years, all markets have had one or more major price moves reachinglevels often greater than twice their normal price. Sugar and silver each topped at 10 times %their starting value. These moves necessitate changes in ‘box size to control the impact of =the increased, and later decreased, volatility. ae
‘Alternating with extremely high prices are periods in which many commodities fall tolevels near their production costs. Table 11-1 shows part of the history of changing box ;sizes based on a 3-box reversal, for agricultural markets during the late 1960s comparedwith the mid-1980s. By noting the historic pricé moves, the change in volatility can be 3related to the change in box size. Whereas most agricultural markets show a pattern of 3small to large to small box sizes, coffee and orange juice have remained volatile. Silver and |gold maintain large box sizes. through the mid-1980s, as a result of their long steady
THE PROBLEM OF RISK 263
a,
 
 
 
 
 
TABLE II-Ib Point-and-Figure Box Sizes1986 1986Commodity Box Size Commodity Box Sizeils CurrenciesCrude 10 pts British pound 50 ptsGasoline 50 pts Canadian dollar 10 ptsHeating oil 50 pts Japanese yen 10 ptsSwiss franc 10 ptsDeutschemark 10 ptsFinancials IndexEurodollars 10 pts S&P S00 50 ptsGNMAs "4s pts Major market 50 ptsTreasury bonds "Ya prs NYSE 50 ptsTreasure bills 10 pts Value line 50 ptsCertificates of déposit 10 pts
a
declines; however, current levels would require a reduction. Rules for varying box sizesand risks associated with these changes will be discussed in the next sections.
The Nature of Markets
Financial markets have underlying differences from agricultural ones. Interest rates havethe greatest similarity, with the exception that a low volatility level for rates is associatedwith high prices. To create a point-and-figure chart for Eurodollars with the same orienta-tion as soybeans, it is necessary to plot the yield, rather than the price, of the market. Thisis easy for any 3-month rate, because the current price can be subtracted from 100; forlonger maturity bonds this is more difficult, but could be estimated by subtracting the cur-rent price from 164, or by dividing 800 by the futures price.
Currencies present another unique problem, because there is no low or high price forforeign exchange, only what the market decides. When an economy strengthens, the value ofthe currency increases; when the economy falters, its currency devalues. Sometimes, as hap-pened in the U.S. from 1985 to 1995, the government may choose to allow the currency todecline as a way to reduce its debt. Does this mean that the U.S. dollar is low and that itsvolatility will decline? No. With agricultural products, when prices fall to production levelsthere is less trading and lower volatility, the result of lack of interest. The dollar, however, cancontinue to decline and its volatility can increase as longvas traders believe that the currentsituation is changing. Therefore, the volatility of a currency is low when market participantssee its price as correct, at equilibrium. If prices move away from equilibrium, and the gov-ernment disapproves of what is happening, economic policy will attempt to move it back;therefore, currency prices can be volatile when they move in either direction away from equi-librium, This makes it difficult to scale prices by a percentage, as we will do in later sections.
THE PROBLEM OF RISK
Igo long or short as close as I can to the danger point, and if the danger becomes real I- close out and take a small loss.Jesse Livermore to Richard Wyckoff®
“Wyckoff, Stock Market Technique, Number One (Wyckoff, New York, 1933, p. 2).264 POINT-AND-FIGURE CHARTING
 
If the point-and-figure method is accepted as successful, why is it necessary to modify thebasic signal and use trendlines and geometric formations to interpret new signals? Theanswer involves the risk of an individual trade. The difference in treatment of the same pricemove can be seen by looking at both a bar chart and a corresponding point-and-figure chartfor the same period (Figure 11-6). The most basic bar chart trading method uses horizontalsupport and resistance trendlines to define a rectangular trading range; when the resistanceline is penetrated, a long position is taken. A stop-loss is placed below the resistance line toclose out the position in the event of a false breakout. An alternate place for the stop-losscould have been below the support line allowing the new bull move some latitude todevelop. The interpreted bar chart makes the selection of the entry point and the placementof stops seem obvious; however, when trading, the placement of the support and resistancelines is not as clear. The time to enter a trade after a breakout is never certain, and the posi-tion for the stop depends on the volatility of pfices and the risk that can be assumed.
In contrast toyhe ambiguity of the bar chart, the point-and-figure method defines thesupport and resistance levels exactly, establishes a place to buy in advance, and designatesthe position for the stop-loss below the rectangular congestion area. The rigidity of themethod allows only one place for the stop-loss and fixes the risk as the difference betweenthe support and resistance lines, a total of 5 boxes in this example. In the bar chart, the riskmight have been held to the equivalent of 2 boxes using the first strategy; however, a verysmall risk often results in being stopped out of the trend prematurely.
TRADING TECHNIQUES
There are alternate methods for selecting point-and-figure entry and exit points that havebecome popular. Buying or selling on a pullback after an initial point-and-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
Af
‘Stop—ioss
‘Support
Bar chart Point—and—figure
 
TRADING TECHNIQULs 265
 
FIGURE 11-7 Entering on a pullback.
 
x260 x° x
28 ox — ~<——— Simple buy, risk 9¢ or $45056 XOXOOOO
2 ~<—— Risk 7¢ or $350oxza OX Ox Risk 5¢ or $250
oxoxox252 OX OKO Risk 3¢ or $150
Ox Oxa50_9 9X5* Risk 1¢ of $60 (support level)
oeOr 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 with a stop-loss at the mini-mum 4-box distance.
FIGURE 11-8 Entering on a confirmation of a new trend after a pullback.
Place your~<— dey order
HmoooceREARso08BOEBoooeeKOR
Original‘stop—loss
Placing your order1266 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 a newhigh 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 tocrease the confirmation threshold from 2 to 3 or 4 boxes as market volatilitycreases. 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 beyond
the area of technical analysis. If the profit currently held in open positions is enough to
sustain a life of leisure, a home in the mountains or South Seas, a country club, and a small
investment in a hotel or restaurant to occupy your time, then take it and run! A trading sys-\
” Adam Hewison, “The Will Rogers Theory of Point & Figure Trading,” Technical Analysis of Stocks & Commodi-ties (August 1991).
 
FIGURE I1-9 Three ways to compound positions.
 
 
    
 
Buy on breakoutof resistance
  
 
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 cuinthe 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