Chapter 6 – Point and Figure Charts of Indicators

The Point and Figure method is really just another way of charting data, just as line and bar charts are. There is, therefore, no reason why they cannot be used for charts other than pure price charts, such as calculated lines, called indicators.

In theory, there is no limit to the indicators that can be drawn using the Point and Figure method. In practice, however, it is wise to consider what the benefits are of doing so. Point and Figure charts are very good at showing trends because a column of XS represents an uptrend and a column of Os represents a downtrend. They are also good at showing reactions against the trend and reassertion ofthe trend. Their sensitivity can be altered to hide or expose minor fluctuations and these fluctuations create congestion patterns which give the analyst more information about the movement. This means Point and Figure charts do not work well on data that has already been smoothed. For example, a Point and Figure of a moving average of the price data is no more useful than drawing a Point and Figure of the price. In fact, it does not give much detail at all as Chart 6-1 shows. The chart is a 50 x 3 Point and Figure of the 20 day moving average of the FTSE 1 00 Index. The average has removed so much of the countertrend noise that the chart reveals nothing important. Compare it with other charts of the FfSE 100 Index shown previously. Obviously as the period ofthe average is reduced, so the Point and Figure reveals more information, but no more information than the price itself. For this reason, Point and Figure charts of moving averages are not recommended.

The implication, therefore, is that Point and Figure charts should not be drawn of any smoothed indicator. Indicators that are smoothed by using ne or other averaging technique means the resultant Point and Figure chart will not be of much use. MACD1 8 and slow stochastic 1 9 are examples of smoothed indicators. That leaves three types of indicator which can be drawn using the Point and Figure method.

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Some are in common use, some are not.

18 MACD, or Moving Average Convergence Divergence is a calculated indicator which plots the difference between two moving averages.

19 Stochastic is a calculated indicator which looks at the relationship of the price high, low and close over selected periods and creates an indicator from the observations.

20 Relative strength is an indicator created by dividing the price of one instrument (usually a share) by the price of another (usually an index). It is either plotted in its raw form or indexed to start at 1 00, which is the preferred method when Point and Figure is used.

21 On-balance volume is a cumulative line constructed by adding or subtracting the period’s volume based on whether the price has risen or fallen.

22 RSI is a weighted, velocity index with a fixed scale ranging between 0 and 1 00. Although it has averaging in its calculation, the resultant line is not smoothed.

23 Momentum is a rate of change indicator measuring the percentage change in price from the period a pre­ determined number of periods ago.

Relative strength20 against another instrument Cumulative lines such as on-balance volume.21 Oscillators such as RSJ22 and momentum.23

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Point and Figure of relative strength

One o f the best and most important indicator charts t o b e drawn using the Point and Figure method is relative strength. The reason is that, unlike many other indicators, the relative strength scaling is mostly irrelevant. What is important is trend, and Point and Figure shows and defines trend better than any other chart. You will recall that the most important trend in 3-box Point and Figure charts is the 45° trend. The 45° trend lines define the main up and downtrends objectively. You recall, the essence of the 45° trend is that to maintain the price action above the trend, the price must rise by more squares than it moves sideways. In relative strength terms this means that the relative strength ratio must rise by more squares than it moves sideways. More squares sideways indicates that the numerator instrument is no longer

performing better than the denominator instrument.

The reason this is important is that fund managers who are benchmarked to an index must try to accumulate shares that have rising relative strength charts and dispose ofthose with falling relative strength charts. This is easy to do in theory but not quite so easy in practice, using the traditional relative strength line chart. The reason is that trend is not quite so defined when a line chart is used.

It is worth noting at this stage that relative strength shows relative performance, not absolute performance. A rising relative strength trend does not mean that the stock (numerator) is rising, it simply means that the stock is performing better than the index (denominator). It could mean that the stock is falling but not by as much as the index; or it could mean that the stock is trading sideways but the index is falling; or it could mean that they are both rising but the stock is rising more than the index. The converse applies with a falling relative strength trend.

When drawing Point and Figure charts of relative strength, scaling becomes an issue because relative strength is a ratio of the price of one instrument to the price of another and therefore has very small or very large numbers. The preferred method, therefore, is to normalise the relative strength data before plotting the chart, by dividing each relative strength value by the first relative strength value in the series and then multiplying by 1 00. This makes construction easier and has the additional benefit that all relative strength charts become directly comparable. Ifthe last value ofthe normalised relative strength chart is 145, this means that the stock has outperformed the benchmark – or denominator – by 45% since the base date. If another relative strength chart shows 163, you can immediately see that it has performed better than the first stock. Of course, if the relative strength chart shows a value of 87, it means the stock has underperformed the benchmark by 13%. This gives a whole new dimension to benchmarking because it allows you to set your benchmark date at one which may be relevant – for example, the start of the year.

It is important to understand, however, that the relative strength chart is exactly the same shape whether you normalise it or not, and is analysed in exactly the same way. It is far more

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difficult to choose a box size when using a raw relative strength chart, because the ratio could be in thousandths.

Point and Figure charts of relative strength are analysed in exactly the same way as Point and Figure charts of price. The relative strength rising above the 45° line is a signal to continue to accumulate the stock at times when the price registers buy signals. Once the relative strength falls to, and breaks, the 45° trend line, it is a time to stop buying and start selling at the most opportune time by looking at the price chart for sell signals.

Before drawing a Point and Figure of relative strength you have to consider the box size and the reversal. You will find that, in general, log scale relative strength charts using a 1% box size are the most effective and show 45° trends better than arithmetic charts. Furthermore, if you are analysing a group of stocks against the same benchmark, you need the relative strength charts to be directly comparable with regard to the time horizon – remember the box size adjusts your time horizon.

Chart 6-2 is a 1% x 3 Point and Figure ofthe relative strength ofBAA plc against the FTSE 100 Index and Chart 6-3 is a 1% x 3 Point and Figure of BAA pIc’s price.

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Chart 6-2: 1 % x 3 Point and Figure of the relative strength of BAA pic against the FTSE 1 00 Index

Trend line 1 in Chart 6-2 is the relative strength bullish support line from the relative strength low, meaning that long positions in BAA plc may be accumulated while the relative strength stays above the 45° line. There is an early invalid break below trend line 1 which allows new

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bullish support line 2 to be drawn. Notice that the relative strength rises away from the bullish support line showing strong relative strength, which in turn means that BAA pic is outperforming the FTSE 100 Index by a wide margin. The reaction halfway up the trend allows internal 45° line 3 to be drawn. This is a shorter-term line which gives early warnings of trend deterioration. This occurs at point A when the internal 45° trend breaks, signalling that any accumulation of the stock should cease for the moment. Breaks of internal lines do not signify disposal: they are an early warning and any buying should cease. The point at which this occurs on the price chart is shown by point A l in Chart 6-3 . A tentative downtrend 45° line, 4, can be drawn on the relative strength chart, which acts as resistance to any up move. This leads the major 45° uptrend line 2 to be broken at point B. This indicates that you

should find opportunities to start disposing of BAA plc and replacing it with another stock which has relative strength in an uptrend. Point B l in the price chart shows the point at which the relative strength broke its uptrend. You should use any strength to sell BAA pic.

Chapter 6 – Point and Figure Charts of Indicators

Chart 6-3: 1 % x 3 Point and Figure chart of BAA pic

Downtrend line 4 is now the valid 45° bearish resistance line on the relative strength Chart 6-2. The breach at point C is not a valid trend line break because there is no Point and Figure signal on the break. It does, however, allow the bearish resistance line to be adjusted to line 5. While the relative strength remains below line 5, you must continue to dispose of any holdings in BAA pic. Depending on your trading style, shorts may be considered as well. The strength of line 5 is reinforced by the test at point D, which failed to breach it. Finally, at point E, the bearish resistance line 5 is breached, signalling that BAA pic can be accumulated again

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when a buy signal emerges on the price chart. The point at which the relative strength trend changes is shown on the price chart by point E 1 . You can see that there is no buy signal at this stage. In fact, the price shows some weakness and a buy doesn’t emerge until the double­ top buy ten columns further on. A new relative strength bullish support line 6 may now be drawn. Internal line 7 may also be drawn to show the shorter-term support. The relative strength remains above line 7 but eventually breaks at point F. Notice that prior to breaking it met resistance forming two tops at the same level. This was the first sign that any relative strength was failing. At this stage, accumulation of the stock should cease. Shortly after this, bullish line 6 breaks as well, indicating that BAA pIc should be disposed of as sell signals emerge from the price chart. Point F l shows the area on the price chart where the relative strength chart bullish support line broke down. A double-bottom, then a triple-bottom sell signal is generated on the price chart.

The new bearish resistance line is now line 8. Below this line the stock should be disposed ofwhether or not it is rising. The reaction at point H on the relative strength chart, and failure to reach bearish resistance line 8, allows internal 45° line 9 to be drawn for the shorter-term view. Downtrend line 9 eventually breaks at point I, shown on the price chart as point 11. From this point, no more selling of the stock should take place. Eventually, the main bearish resistance line 8 is broken at point J, which is point J 1 on the price chart. From this point the stock can again be accumulated on any buy signals on the price chart.

With the break on downtrend line 8, new bullish support line 10 may be drawn from the bottom. At the same time, internal 45° line 1 1 may be drawn from the reaction low at the break. The relative strength remains above this line for over two years, during which time the FTSE 1 00 Index declined but BAA pIc went sideways. This is a good example of a rising relative strength line not necessarily meaning that the price is rising. The breach of the internal trend line 1 1 at point K indicates that any accumulation should cease from point K l on the price chart. Notice that the relative strength again ran into resistance just prior to the

break, creating a M-shaped top pattern.

As usual, the breach of the internal trend line 1 1 allows a tentative downtrend bearish resistance line 12 to be drawn. Notice how the relative strength line rises up to this new bearish resistance line but cannot break through. Instead it goes on to break the main bullish support line 1 0 at point L, which is point L I on the price chart. At this point, BAA pIc should be disposed of whenever there is a sell signal. Notice how the price continues to rise but the relative strength continues to fall, showing that BAA pIc is performing worse than the market.

This example has shown just one relative strength chart where the same stock is accumulated and disposed of each time the relative strength trend changes. In reality, there will be many relative strength charts turning negative or positive, so having disposed of one stock, another may be accumulated when its relative strength turns positive.

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Chapter 6 – Point and Figure Charts of Indicators

Although trend lines play an important part in relative strength analysis, normal Point and Figure pattern signals apply as well. Trends are most important because the trend of the relative strength chart tells you whether the stock is performing better or worse than the index.

Most Point and Figure of relative strength analysts use 3 -box reversal charts but I -box charts are effective too. Remember, however, that 45° trend lines are not as important on I-box charts; subjective trend lines are used instead. Chart 6-4 and Chart 6-5 follow on from one another and show a I% x 1 relative strength Point and Figure of BAA pIc against the FTSE 100 Index. Notice that although the trend lines are not at 45° they are still very effective at showing the relative strength trends.

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Chart 6-4: 1 % x 1 Point and Figure chart of the relative strength of BAA pic against the FTSE 1 00 Index (chart 1 of 2)

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Chart 6-6 is a relative strength chart of Carnival pIc against the FTSE All Share Index. It has provided an excellent vertical and horizontal count. The likelihood of other counts being achieved is increased by the accuracy of these.

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Chart 6-6: Showing counts on the 1 x 3 chart of the relative strength of Carnival pic against the FTSE All Share Index

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The relative strength chart of Cairn Energy pic against the FTSE ALL Share Index, shown in Chart 6-7, has also generated some accurate vertical and horizontal counts. Note the downside vertical count of 1120 has been exceeded, indicating further downside of the relative strength to come. Remember, when a count is exceeded, this indicates a strong trend , in the direction of the count.

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Chart 6-7: Showing counts on the 1 0 x 3 chart of the relative strength of Cairn Energy pic against the FTSE All Share Index

So remember to always check past counts to see how accurate they have been. If they have, then new counts are likely to be as well. Always consider the trend when assessing counts. Downside counts in an uptrend are unlikely to be achieved, as are upside counts in a downtrend. Remember, too, that counts will give you some idea ofwhere the relative strength trend will pause. That is all they can do. It’s a maj or advantage of Point and Figure charts of relative strength; no other chart is able to give you an estimate as to where relative strength is headed.

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Chapter 6 – Point and Figure Charts of Indicators

Point and Figure of on-balance volume

Point and Figure charts don’t show volume but volume may be incorporated by drawing Point and Figure charts of on-balance volume (OBV). It lends itself to the Point and Figure representation because it is a cumulative line where the values that are used to construct the line have no meaning. As with relative strength, the main analysis of OBV is the trend. A rising trend in an OBV chart indicates accumulation, whereas a falling trend indicates distribution. OBV shows the presence of informed buyers and sellers. It can show accumulation taking place prior to a price rise and distribution prior to a price fall. The rationale behind it is that high volume combined with a price move indicates powerful informed investors taking positions. For this reason, it can show the presence of trading on sensitive information.

The biggest problem with Point and Figure of OBV is that it can have large values, depending on the volume of the share in question. This makes choosing a box size extremely difficult. Unfortunately, using log scale OBV charts does not help because percentage changes in OBV have no meaning. The best method of approximating a box size is to use an arithmetic box sizewhichis 1%oftherangeofOBVvaluesinsteadof1%ofthelatestvalue.Thiswillgive you a sensible Point and Figure chart which may require some adjustment after first viewing.

Chart 6-8 is a 3-box reversal Point and Figure chart of the OBV of BG Group pIc. Point and Figure charts of OBV are analysed and interpreted in exactly the same way as any other Point and Figure chart. Notice the downtrend being broken by a very strong X column rise, marked A on the chart. This is the beginning ofa new uptrend in OBV and strong accumulation. Chart 6-9 shows the price line chart of BG Group pIc. The point at which the buy signal is given on the OBV chart is shown by point A l on the line chart. The OBV enhances any price move.

Notice the vertical count of 1 750000 from the breakout column was achieved almost exactly, at which point the OBV gave a triple-bottom sell, the first sell signal during the entire uptrend. With accumulation coming to an end, profits must be taken. The OBV proceeded to consolidate sideways within a large triangle pattern. The breakout with a triple-top buy signal from the triangle occurs at point B on the OBV chart. This is shown on the price line chart by point B l . Note also, that this occurs before the price itself has broken out, creating another good buying opportunity. Vertical and horizontal counts are available from the pattern. The vertical count is exceeded, indicating a strong trend. The horizontal count has not yet been achieved. Notice that in the case of both the uptrends started at points A and B, there is no double-bottom sell signal given during the trend. A series of double-top buys is a signal to add to long positions.

Experienced OBV followers will be able to ascertain the likely consequences on a share price with such a potential rise in OBY.

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Chapter 6 – Point and Figure Charts of Indicators

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Point and Figure of oscillators

In theory any oscillator may be drawn as a Point and Figure chart. As stated earlier, smoothed oscillators such as MACD should, however, be avoided, as the lack of minor trend changes results in long columns of XS and Os which render the Point and Figure chart useless. Remember, Point and Figure charts thrive on reversals. Oscillators such as momentum, overbought/oversold, commodity channel Index and RSI do work well in Point and Figure format, but there is, in fact no limit to the indicators that can be drawn using Point and Figure charts rather than line charts.

It is important not to lose sight of the reason for drawing a Point and Figure chart, rather than a line chart, of the oscillator. It is to benefit from the filter, as well as the clear signals, that Point and Figure charts offer. Chart 6- 1 0 shows a 1 x 3 Point and Figure chart of the 1 4 day RSI of IBM Corp. The centre window shows a line chart of the same RSI and the lower window shows the price line. The charts have been lined up so as to match approximately, although remember the line charts are governed by a date scale whereas the Point and Figure chart is not.

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