Capital Properties FX
Capital Properties FX

Point and Figure Chart Patterns – Trading the Oldest Market Theory


Trading in the 21st– century is unimaginable without computers. The personal computer brought tremendous ease to use indicators and interpret historical prices. But old trading techniques like point and figure prove that trading markets never change.

It may be that some markets disappear (i.e., fixed income market lost a lot of its volatility since the quantitative easing in major economies) and brand-new ones come to existence (e.g., foreign exchange after the 1970s, crypto-currencies in the last years), but old trading techniques continue to work.

With hundred-and-forty years of existence, point and figure charting is one of the oldest trading theories that exists. As a comparison, imagine that Ralph Elliott developed the Elliott Waves Theory in the 1930s.

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Or, we can track the start of the Gartley trading method back to early 1900. Yet, neither Elliott nor Gartley or any other trading theory, as a matter of fact, is so old like point and figure.

What’s interesting about point and figure is that the theory changed in time. In fact, we can say that it adapted, it changed with the markets. And, with the technology.

To the surprise of many, such a veteran trading strategy still works in the 21st– century. Many traders nowadays prefer it as it is renowned for considering the time factor, something that missed from almost every other trading theory.

Only the Elliott Waves Theory considers time too. However, that’s not a constant characteristic when trading with Elliott, but rather some patterns allow the interpretation or time, together with price.

W.H. Gann was the first to use time in its market analyses. He firmly believed that time, together with price, form the holy grail in trading.

Point and figure does just that. For this reason, traders still use it.

Constructing Point and Figure Charts

For a trading technique born in the late 1800s, point and figure remains one of the most innovative trading ideas. The first thing that attracts attention when looking at a point and figure chart is how it distorts the time.

The easiest way to illustrate that is to compare two distinct charts. First, here’s how a daily chart looks like on the EURAUD currency pair. All the candlesticks on this daily chart combined show one-year worth of price action.

 

Next, applying the point and figure charting technique on the same currency pair reveals something astounding: time “shrinks.”

On the same screen, the point and figure chart shows no less than sixteen years of price action. Not one, but fifteen years! How is that even possible?

The answer is quite simple. Point and figure charts do not distort time.

Instead, they filter the “noise” in a regular chart. Simply put, point and figure trading means not accounting for trading days when the market doesn’t move.

The lack of activity is just ignored. And this is what makes point and figure trading such an essential approach to today’s traders!

On a classic daily chart, one entry is created for each day. For a point and figure chart to plot something (either an X or a 0, as we’ll show later in this article), the market must move beyond a certain point. If not, the chart remains as it is.

In other words, from a point and figure perspective, some trading days are more important than others. Or, simply put, a point and figure chart is not affected by inactive trading days. It just uses appropriate intraday price action.

X’s and O’s – the Basis of Point and Figure Charts

As you noted already, X’s and O’s are the basis of point and figure charting. They show rising columns (X’s) or falling columns (O’s). Or, bullish or bearish price action on the daily chart. Relevant price action!

To understand how point and figure charting works, we need to start from the basics. Right from the start, we must define what a relevant trading day is for the market to interpret.

As all traders know by now, markets have various volatility levels. Some currency pairs, for instance, travel larger distances than other ones.

For instance, the GBPJPY pair has a bigger daily range than, say, the AUDCAD cross. Hence, for a proper construction of a point and figure chart, we need to define a relevant daily range for each market to chart.

That’s easy now as trading platforms allow the calculation of the ATR (Average True Range) automatically. All traders need to do is to set the proper input, indicating the number of days to consider.

The ATR Length number 14 tells that this chart uses the ATR for the last 14 periods (days). However, traders can change it as they want, considering the particularities of every market.

Moreover, besides setting the ATR, traders must decide how the chart will be constructed. Or, they must decide on the source of data.

In the example above the source is HL. It tells us that the chart considers the high or the low at the end of the day.

Also called the Cohen method (after A.W. Cohen of Chartcraft who proposed this method in the late 1940’s), it is favored by many traders still. However, another method exists, when the chart uses the close at the end of the trading day.

Understanding Point and Figure Charts

There’s a difference between the two point and figure charts that result. For this reason, it is a big controversy which one is the most accurate solution.

In any case, both chart types reveal the relevant information needed. As a rule of thumb, the higher the ATR number, the more comprised the point and figure chart becomes.

As mentioned earlier, the X’s are used for rising columns (bullish price action) while O’s show falling columns (bearish price action). Initially, traders used the so-called 1-box reversal to plot the X’s and O’s.[adsanity id=”15344″ align=”aligncenter”/]

For instance, let’s assume that the ATR considered on the EURAUD pair is 100 pips. And, the method used is the close of the previous day.

We can see that the market closed the previous day at 1.58802.

Using a 1-box reversal, the point and figure chart plots an X or O for every move that exceeds 100 pips. More precisely, an X for every 100 pips higher, and an O for every 100 pips lower.

This, too, changed in time. For traders wanted to filter inactive trading days, even more, 2-box, 3-box, and even 5-box charting exists. Therefore, a 2-box point and figure chart will plot an X or O only if the market advances or declines 200 pips.

A quick look at the settings revealed earlier, shows that the chart uses a 3-box reversal. That is, it will plot an X or O only if the intraday price action exceeds three times the ATR of the last 14 days.

And now you understand the basics under the construction of a point and figure chart like the one below.

Next, let’s have a look at some ways to trade point and figure charts. As you’re about to find out, they offer a unique point of view at any market that moves.

How to Trade with Point and Figure

In time, the 3-box reversal method became the most popular one. Its biggest advantage is that only shows the relevant market moves while keeping the basic shapes of traditional patterns.

Trading with point and figure charts is straightforward. Because the chart already filters for inactive trading days, when the chart changes, it implies that the market is on the move. Hence, traders are ready to act.

Depending on the approach, traders favor one trading method over another. Here are some of the most important ones:

  • trading previous swings’ highs or lows
  • drawing objective 45 degrees lines
  • trading moving average reversals

Interpreting Previous Swings’ Highs or Lows

This approach uses the trending techniques we all know from classic charting. A trend’s definition is:

  • a series of higher highs and higher lows (bullish trend)
  • a series of lower lows and lower highs (bearish trend)

Following the same principle, a sell signal using point and figure charting occurs when a column of O’s falls below the previous column of O’s. While, at the same time, the X’s column doesn’t exceed the previous two swings highs (that would be a reversal).

 

The EURAUD chart above shows three bearish signals. The pair kept making new lower lows. And, at the same time, the pair failed to break the previous two lower highs. Until a reversal appeared!

 

From that moment on, a bullish trend started. Every time the chart can put another column of X’s that exceeds the previous one, that’s an entry on the long side.

Note that using point and figure charting shows that the EURAUD pair was trading in a bullish trend for the entire 2018. And, at the time this article is written, the bullish trend remains intact.

Using Objective 45 Degrees Lines

All traders heard off trend lines. The line of the trend is the one that defines it, showing precisely what the market does.

However, few traders know that trend lines are of multiple types. Some, for instance, are subjective trend lines. It means that they connect higher lows (in bullish trends) and lower lows (in bearish trends). These are the trend lines used by all traders.

But other ones exist. Called objective trend lines, they follow a 45 degrees angle from highs or lows.

Evidence exists that the market reacts at 45 degrees angles. Because initially, all point and figure charts showed the boxes to put the X’s and O’s, it was relatively easy to draw the lines respecting the angle.

Nowadays, the boxes disappeared from some platforms, including the one used in this example. But we can easily substitute them with one vertical and one horizontal line from a top or bottom. Next, traders use a regular trend line to find the approximate 45 degrees angle. It should provide substantial support or resistance, and a break of it signals the end of the previous trend.

As the chart shows, we used one vertical and one horizontal line to find the 90-degree angle. Next, we drew a regular trend line that respects the 45 degrees angle. Following these two steps make it easier to find the internal 45 degrees angle objective line.

The break of it means the market ended the bullish trend. However, because the column of O’s didn’t break below the previous two higher lows, it is too early to draw the internal 45 degrees trend line corresponding to the bearish trend.

45 Degrees Trend Lines – Important Functions

Point and figure analysts use the internal lines in two ways. One is to find out important support and resistance levels.

When the columns of X’s and O’s approach the trend line, the support or resistance becomes stronger. In fact, the closer they get to the trend line, the stronger the support or resistance becomes.

So, one function of the 45 degrees trend line is to provide critical support and resistance levels. But the line serves an even more important purpose: it shows the end of the trending conditions. Because of that, traders use it to define proper risk-reward ratios and to set the exit from a trade.

Using Moving Averages to Trade Point and Figure Charts

Moving averages are great ways to distinguish bullish from bearish markets. The rule says that when the price remains above a moving average, the market is in a bullish stance. A bearish market, therefore, needs the price below the average.

In the case of point and figure charts, moving averages reflect more accurate levels. Because the chart accounts for market inactivity, the key is to use slower moving averages in interpreting point and figure charts.

 

The point and figure chart example from above has the MA(20) and MA(9), and their cross signal a bullish or bearish market.

Conclusion

Point and figure analysts documented and still document patterns on such charts. The only reason why point and figure charts are used today, a century and a half after they appeared for the first time, is because the trading technique adapted in time.

A point and figure strategy differs from one using classic candlesticks pattern. It filters from the market’s inactivity, thus avoiding periods of consolidation.

Perhaps one of the most important innovations in point and figure charting came with the use of the logarithmic scale. The P.C’s invention made it possible to develop technical analysis software able to do that easily.

If you think that this approach exists only since the 1980s, you’ll see why point and figure is one of the most respected and highly valued trading theories that exist. It stood the test of time and will most likely survive for as long as trading exists. [adsanity id=”15347″ align=”aligncenter”/]