In the technical analysis, different charting methods plot the price activity of financial instruments such as shares and currencies. Traders and investors, therefore, use these charts as a guide for predicting future market trends. One of the excellent techniques for determining fluctuation in commodities or stocks is the Point and Figure (P&F) chart. This differs from traditional bar or candlestick charts, which plot price against time, while P&F charts deal only with price movements and discard the time element. This is interesting because it gives a different perspective on market dynamics, making the P&F chart of value in recognising the emergence of new trends and potential reversal points.
Definition and Meaning of Point and Figure Charts
The fact that the Point and Figure charts do not consider the time factor makes them different from other charts. This does not show the change in price against a timescale. For instance, the market is portrayed by a line of Xs and Os, in which each X and O substitute for a rising and falling price. The chart is laid out on a predetermined price scale, with the box size or reversal amount determining the minimum price movement required to plot a new X or O.
How Point and Figure Charts Work
The mechanics of building a Point and Figure chart are pretty simple. This is how it works:
- Choose box size: The first step is the choice of box size, which would be the minimum movement in price required for plotting a new X or O. For example, if the size of the box is set at ₹1 for a stock trading at ₹50, it means that the stock price will have to advance by ₹1 minimum before a new X or O is plotted.
- Plotting Xs and Os: Plotting an X on the chart is done in case it moves to higher levels. More Xs will follow in that column. On the contrary, if the box size reduces the price, an O is plotted to the right in the new column. Successive falling prices will, therefore, result in more plotted O's in the same column.
- Reversal Criteria: It is the price at which the Reversal Amount is set. The aim is to change the direction of columns from X's to O's (or vice versa). Reversal criteria are built with the ability to set the reversal amount on the level of multiple box sizes, e.g., three to four times the box size.
- Trend Lines With Support/Resistance: Trend lines drawn after plotting X's and O's can indicate potential support and resistance areas. These lines connect two or more adjacent columns of X's or O's and signal the direction of prevailing price movement.
Benefits of Point and Figure Charts
Point and Figure charts offer several advantages over traditional time-based charts:
- Removal of time factor: This excludes the time factor from the chart since, in many cases, it distorts the charts and clutters the vision of many traders in time-based charts.
- Identification of trends: The emergence and reversals of the P&F charts are great tools in identifying the emergence of a trend and finding a likely change in trend direction. Changes in direction and momentum are easily seen due to a clear picture of Xs and Os.
- Support and Resistance Levels: Trend lines produced across P&F charts delineate potential support and resistance areas, providing information on entry and exit points.
- Simplicity: Though one of the approaches is very different from all others, P&F charts are comparatively simple in communicating their data and, hence, easily understood by both novices and professionals in the field.
Applications in Trading of Point and Figure Charts
The typical applications of P&F charts in trading are as follows:
- Trend Finding: Only the prevailing trend and its strength are examined by X's and O's columns. Long columns mean that a strong trend is developing, while short columns signify that the market is preparing for a change in trend.
- Entry and Exit Points: Potential entry and exit points in the trend lines drawn on the P&F charts. In certain situations, a trader may wish to exit from an extended position should the price fall below a trend line of support or go long after breaking an upward trend line of resistance.
- Triple Top and Triple Bottom Patterns: Triple top and triple bottom patterns are observed through P&F charts, which offer pretty dependable signals for reversal.
- Objective Analysis: The P&F chart reduces the degree of subjectivity of the observer caused by time-based patterns by eliminating the time aspect and providing an objective perspective of price changes.
Limitations and Considerations
Point and figure charts represent different angles on price movements and have certain limitations and considerations to be considered.
- Time Information: As we know, P'&F' charts have no time during their analysis; therefore, the speed at which prices change or the time they have been changing may not be well represented against the timeline. Some strategies need both duration and speed.
- Sensitivity to Box Size and Reversal Amount: The choice of box size and reversal amount could significantly influence the appearance and interpretation of a P&F chart. Thus, traders should base their parameters on the trading style and the volatility of the financial instrument.
- Delayed Signals: The very nature of these charts could give signals that are adversely delayed compared to time-based charts due to the possibility of missed opportunity or late entry.
- Limited Applicability: Although P&F charts have value in analysing trends and finding likely points of trend reversals, they offer little value about other techniques involving a pattern or indicator analysis based on time.
Conclusion
Point and Figure charts are visually attractive and very different in price movement definition within financial markets. When one takes time out of the equation and focuses solely on price changes, the Point and Figure chart shows trends and possible turning points very well. Despite the limitations, P&F charts have real value in a trader's toolkit. Understanding the mechanics and applications of the Point and Figure chart can afford traders a fresh perspective on market dynamics and enhance trading decisions.
What is the primary difference between Point and Figure charts and traditional time-based charts?
Point and Figure charts do not plot price against time. Instead, they focus solely on price movements, disregarding the time element entirely. Traditional charts, such as bar or candlestick charts, plot prices against a time scale, typically showing price movements over a specific period.
How is the box size determined in a Point and Figure chart?
The box size and reversal amount represent the minimum price movement required to plot a new X or O on the chart. It is usually determined based on the volatility of the charted financial instrument and the trader's preferences.
What is the purpose of the reversal amount in Point and Figure charts?
The reversal amount is the price movement required to change the column direction from X's to O's or vice versa. It is typically set as a multiple of the box size, three or four times the box size. The reversal amount helps filter out minor price fluctuations and identify potential trend reversals.
Can Point and Figure charts be used for all financial instruments?
Point and Figure charts can apply to various financial instruments, including stocks, futures, currencies, and commodities. The principles remain the same, but the box size and reversal amount may need to be adjusted based on the volatility and price characteristics of the specific instrument.
How are trend lines drawn on Point and Figure charts?
Trend lines on Point and Figure charts are formed by connecting two adjacent columns of X's or O's. These lines represent the prevailing trend direction and can serve as potential support and resistance levels.