Chapter 9 – Advanced Point and Figure Techniques

The standard way to establish and expose trends in Point and Figure charts is with trend lines. However, it is possible to apply other techniques instead, ones that are usually reserved for bar and line charts. This chapter will explore the application of moving averages30, parabolic SAR31 and Bollinger Bands32 to Point and Figure charts with the aim of providing additional trend information, which will in turn enhance the validity of any standard Point and Figure buy or sell signals. The particular success of these techniques will stem from the unique way in which they are calculated when Point and Figure is the base chart on which they are applied.

Moving averages on Point and Figure

The concept of moving averages on Point and Figure charts is alien to most, as it is recognised that Point and Figure charts do not have a time-scale and, of course, everyone knows that moving averages are the price averaged over a time period. Kenneth Tower, however, introduced moving averages based on Point and Figure charts in his chapter on the subject in the book, New Thinking in TechnicalAnalysis, edited by Rick Bensignor. The basis ofthe technique is that, whereas moving averages on bar, candle and line charts are based on a number oftime periods, moving averages on Point and Figure charts are based on a number of columns. To clarify, you are averaging the price per reversal rather than price per unit of time. Price per reversal is price per column change, which is really price per change in intermediate trend. The more sensitive the Point and Figure chart, therefore, the more column changes there will be.

Tower calculates the price on which the moving average is based by taking the price at the centre ofeach column. In columns where there is an odd number ofboxes it will be the centre box. For example, in a 1 0 x 3 Point and Figure chart where a column runs from 40 to 80 (see Figure 9-1), the centre box is 60, so 60 is used as the figure that represents the column.

Chapter 9 – Advanced Point and Figure Techniques

30 A moving average on a price chart is the average of a predetermined number of prices calculated on a moving basis, so that the average moves forward as the next price is included and the first price is excluded.

31 The parabolic stop and reverse (SAR) that was developed by J. Welles Wilder in the mid-1970s. It is a trend definition system which has a parabolic shape which moves closer to the price as the price trend matures.

32 Bollinger Bands were developed by John Bollinger. They are volatility bands around a central moving average, where the upper and lower bands are a predefined number of standard deviations away from the moving average.

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Figure 9-1 : Showing the centre box in the column for moving average calculation

An even number ofboxes in a column creates a problem, however, because there is no centre box. If the column runs from 40 to 70 with 4 boxes, then the centre of the column is taken, which is (70+40)/2 = 55. In essence this is the same logic as used on odd box columns above: (80+40)/2 = 60.

Once you have the representative, or proxy, value for each column, you may calculate moving averages using these values. Decide on the number of columns for the average and calculate it on a moving basis. There are many excellent texts on moving averages, so there is no point in discussing how these are calculated. As with moving averages on bar, line or candle charts, so moving averages on Point and Figure charts can, and should, use a number of calculation methods such as simple arithmetic, exponential, weighted, adaptive, regression, etc.

The first decision to make is how many columns to average. This is no different from having to decide how many days to average on a daily line or bar chart. With a Point and Figure chart, it is related to the width of the Point and Figure chart itself. Consequently, a moving average on a close only Point and Figure chart will trace a completely different path from one on a high/low chart. A moving average on a 3-box reversal chart will look completely different from one on a I -box chart, even if the box size is the same.

Chart 9-1 is a 50 x 3 Point and Figure based on the end-of-day close ofthe FTSE 100 Index. Chart 9-2 is also a 50 x 3 Point and Figure chart but based on the end-of-day high/low. Chart 9-3 is a 50 x 1 , based on the close. In each case a 2 1 column moving average has been drawn. Notice how well the 2 1 column moving average contains the price and traces out the trends in Chart 9- 1 , whereas in Chart 9-2 it is not quite as effective. Notice that the moving average in Chart 9-3 , the 50 x 1 close chart, seems to trace out a similar path to that in Chart 9-2, the 50 x 3 high/low chart.

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Chart 9-3: 50 x 1 of the FTSE 100 Index with a 21 column simple moving average

What this means is that you cannot use the same length (measured in columns) moving average across different box sizes, different reversals and different construction methods. So, the choice of moving average length is much more complex for Point and Figure than it is when using line charts. The pay-off, however, is that existing Point and Figure signals are enhanced by the use of moving averages.

The main purpose ofusing moving averages on Point and Figure charts is to define the trend which may not be obvious at the time. An upward sloping moving average indicates the price is in an uptrend, and a downward sloping moving average indicates the price is in a downtrend. Moving averages expose trends that cannot be seen by looking at the raw price, in the same way that trend lines do. This is most useful in Point and Figure charts, because knowing the trend helps to decide whether an initial Point and Figure buy or sell signal should be taken. Remember, opening a trade with a buy signal in a downtrend is far riskier than opening a trade with a buy signal in an uptrend. If a moving average is used, therefore, the trend of the moving average needs to be ascertained.

The difficulty is knowing when the trend of the moving average has changed. The best and most common way to do this is to use two moving averages. When the lesser length moving average crosses above the greater length moving average, the trend changes to up; when it crosses below, the trend changes to down. What remains, therefore, is to decide what lengths of moving average to use. Remember, time has nothing to do with it. Moving average lengths are in columns. This means that the wider the congestion areas, the greater the number of columns that are required.

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The benefit of Point and Figure charts over bar or line charts is that they already have an unambiguous signal generator with the standard double-top and bottom signals. Adding moving averages to the chart helps to confirm or reject a Point and Figure signal that is already there. This means that the length of the averages is not quite as critical, which is a good thing because the range of available lengths is far less. For example, while a 200 day moving average is quite useful in exposing the longer-term trend on a bar chart, a 200 column average on a Point and Figure chart is ofno significance at all; it may actually be impossible to draw because there may not be 200 columns to average. In any case, to expose the longer­

term trend in a Point and Figure chart, you may simply increase the box size. It is likely, therefore, that the range of moving average lengths will be somewhere between 5 columns and 50 columns in normal use. When using two moving averages with Point and Figure charts, the interplay tends to be best when one moving average is around double the length of the other. This means you could use 5 and 10, or 12 and 24, or 10 and 20, etc., but this allows too many combinations, making the choice and consistency more difficult. Ifyou wish to narrow the choice, therefore, the use of Fibonacci numbers is a good option for moving average lengths. Combinations such as 3 and 5, 5 and 8, 8 and 13, 13 and 21, 21 and 34, 34 and 55 are recommended. You may also use a combination of these, such as 8 and 2 1 , or 1 3 and 55.

Unfortunately, deciding which combination to use can only be assessed by trial and error and inspection. Remember, Technical Analysis is the study of the past in the belief that it can help with predicting the future. A chart with wide congestion areas may require longer moving averages, so I-box reversal charts and charts constructed with high/low data will require longer length averages than 3-box charts using close only data. After drawing a few, you will quickly be able to predict which combination is best for the chart you are looking at and the trends you wish to expose. The shorter the moving average, the shorter-term the trend exposed.

Finally, there are many ways to calculate moving averages. Simple arithmetic moving averages assign equal weights to the prices in the series, whereas exponential moving averages assign a greater weight to the latest price. Exponential averages, therefore, react to the latest figure in the series quicker than simple averages and thus react quicker to any change in direction. This is especially important for moving averages of Point and Figure, because the representative price is the centre ofthe column, not the latest price, and the centre of the column will always lag the latest price, so simple moving averages will be slower to react to change.

How to use moving averages on Point and Figure charts

Before embarking on the use of moving averages, consider why they are being used in the first place. They are used to help you accept or reject any standard Point and Figure buy or sell signal by reason that the signal is with or against the trend. The trend, remember, is determined at the crossover point of the two moving averages you choose.

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With bar and line charts, a buy signal is indicated immediately when the shorter moving average crosses above the longer and a sell when the shorter crosses below the longer. Point and Figure charts already have their own signalling mechanisms, which were discussed in chapter 3. Therefore, what the moving averages are doing is confirming or rejecting the Point and Figure signals as they occur.

As you are aware, the way signals are interpreted in 3-box reversal charts is different from 1- box charts. The double-top and double-bottom signals in 3-box charts are unambiguous and so are easier to interpret. This does not apply to I -box charts where the signals are catapult and fulcrum patterns. Many would say 3-box chart signals are more clear-cut. That is true, but it is not a reason to ignore moving averages on I -box reversal charts. Both are discussed below. Anything that applies to 3-box charts also applies to 2-box and 5-box charts, as their signalling mechanisms are the same.

Moving averages on 3-box reversal charts

With 3-box reversal charts, a buy signal is only registered by a double-top breakout which occurs after the shorter-length moving average has crossed above the longer-length. The converse is true for sell signals. The averages, therefore, should be used to filter out false signals using the following guidelines:

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Conversely:

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These are guidelines which may be adjusted according to your trading style. For example, a short-term trader may take double-bottom sell signals to close long positions while the moving averages are in bullish mode, but only open shorts on a double-bottom sell when the averages are in bearish mode. Conversely, double-top buys when the averages are in bearish mode may be used to close short positions.

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Take the first double-top buy signal after the shorter-length average has crossed above the longer.

Subsequent double-top buy signals remain valid while the shorter average remains

above the longer.

Ignore any double-bottom sell signals when the shorter average is above the longer.

Take the first double-bottom sell signal after the shorter-length average has crossed below the longer.

Subsequent double-bottom sell signals remain valid while the shorter average remains

below the longer.

Ignore any double-top buy signals when the shorter average is below the longer.

Using a moving average filter greatly enhances the signals generated from your Point and Figure chart.

Chart 9-4 is a 50 x 3 close only Point and Figure chart of the FTSE 100 Index with exponential 5- and 8-column moving averages. Notice how well these relatively short-length moving averages define the main uptrend AB and downtrend CD. At no time during the long downtrend CD did the red shorter-length moving average cross above the longer blue moving average, keeping you from opening a long position during the downtrend. The section outlined in black is shown in greater detail in Chart 9-5.

Chapter 9 – Advanced Point and Figure Techniques

Chart 9-4: 50 x 3 ofthe FTSE 100 Index with 5- and 8-column exponential moving averages. Inset shown in Chart 9-5

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Thefirstdouble-bottomsellsignaloftrendABfromthe 1987lowoccursatpoint(a)onChart 9-5 when the 5-column average crosses below the 8-column and, thereafter, a double-bottom sell signal is indicated. Notice that this can only happen to the right of the crossover column, marked with the vertical line. The next buy signal occurs at point (b) when a double-top buy signal is generated after the 5-column average crosses above the 8-column average. Again, this can only occur after the crossover column is compete. The next sell is at point (c).

The 5-column average then crosses back above the 8-column again at point 1 . This is a signal to look for buy signals. Any double-top buy signal to the right of the vertical line marked 1 must be taken, but none occurs and the averages cross back down again at point 2. There is no double-bottom sell signal after point 2 either, and the 5-column average crosses back above the 8-column at point 3. Once again the chart is on buy alert, but again there is no double-top buy signal, so the price remains in a sell mode governed by the last sell at point (c).

The averages cross down again, signalling a repeat double-bottom sell at point (d). Then the 5-column crosses above the 8-column again. Once again, any buy signal to the right of the crossover line must be taken, so the double-top buy at point (e) is valid. This is reversed by the double-bottom sell signal at point (f) when the 5-column crosses below the 8-column. Notice that this sell came before the big sell-off from the top.

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Using moving averages, therefore, has allowed you to filter out the numerous buy and sell signals that occurred during the very difficult top that developed between 1999 and 2001. They are not perfect but it gives you an unambiguous way of deciding when to accept or reject the standard Point and Figure signals.

Shortening the moving average lengths to 3 and 5 columns in Chart 9-6 improves the signals without adding any additional false signals to the chart. Sell signal (a) is generated earlier, as is buy signal (b), as well as sell signals (c) and (t).

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Although the averages do cross-over during the CD downtrend, there are no false buy signals because no double-top buy is generated after the 3-column crossed above the 5-column, as shown in Chart 9-7. Despite crossover points at (g) and (h), no double-top buy signal

occurred.

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There are two things you will have observed. The first is the added dimension ofthe position of the moving averages in determining if a Point and Figure buy or sell signal is valid. This greatly enhances the standard signals generated from a Point and Figure chart. The second is that the lengths of the moving averages are short. Trying 8 and 13 and 13 and 21, does nothing to improve the signals but does result in greater delays. The reason for this is that there are only a certain number of possible signal points within the trend.

Changing the box size changes the time horizon and produces wider congestion areas, but this does not require the averages to be lengthened. Chart 9-8 is a 25 x 3 chart using 5- and 8- column exponential averages. The valid buy and sell signals are marked by the blue (buy) and red (sell) horizontal lines.

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Chart 9-7: 50 x 3 of the FTSE 100 Index with 3- and 5-column exponential moving averages

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Chart 9-8: 25 x 3 of the FTSE 1 00 Index with 5- and 8-column exponential moving averages

Moving averages on 1-box reversal charts

In the same way that moving averages expose the trend in 3-box charts, they also expose them in I -box charts. The use of moving averages on I -box charts is slightly different because the characteristics of I-box charts are different from those of 3-box charts. I-box charts change columns every time the price changes direction by one box, and consequently the congestion areas are wider. Whereas a strong uptrend in a 3-box chart could be a single column of Xs, in a I -box chart it could be a series of small ascending congestion areas.

When the shorter-length moving average crosses above the longer on a I -box chart it does not mean you must take the very next double-top signal. It means you must tum your attention to looking for either bullish fulcrums or semi-catapults and must ignore any bearish ones. This brings a new dimension to I -box analysis where, during the formation of a bullish fulcrum, there can be smaller bearish semi-catapults forming.

In general, because there are more columns per move from one price area to the next, the length of the moving averages normally needs to be increased, but this is not always the case.

Chart 9-9 is the same instrument again, the FTSE 100 Index, but this time the chart is a 1- box reversal 50 x I chart. The averages are the same lengths, 5 and 8. When the red average

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is above the blue you look for bullish semi-catapult and fulcrum signals, and ignore any bearish ones. Shaded area A shows a bearish inverted fulcrum which occurred after the break of trend line 1 . Normally this would be a strong sell signal, but the moving averages show that the trend is still up and that the inverted fulcrum should be ignored.

Shaded area B shows a similar situation. The position of the moving averages allows you to ignore what would otherwise be a sell signal from a small fulcrum top.

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Chart 9-9: 50 x 1 of the FTSE 1 00 Index with 5- and 8-column exponential moving averages

Using such short-length moving averages on I -box charts with their wider congestion areas does result in a number of false signals and whipsaws, which are buy and sell signals in quick succession. You will find that increasing the gap between the averages helps. Instead of using consecutive Fibonacci numbers, you will find that skipping one or two numbers produces very acceptable moving average combinations, such as 5 and 21, 8 and 21, or 5 and 13. As always, try drawing a few, look back on the chart, see how the averages have performed and that will tell you what to expect in the future. This is the very reason Technical Analysts draw charts; so they can look back and learn.

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The false buy signal in shaded area A in Chart 9-10, using moving average periods of 5 and 8, is eliminated in Chart 9-11 when lengths of 8 and 21 are used. Don’t be afraid to experiment. Lengthening averages does lead to a signal lag but it also improves the reliability of the signals.

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Chart 9-1 0: 50 x 1 of the FTSE 1 00 Index with 5- and 8-column exponential moving averages

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Chart 9-11: 50 x 3 ofthe FTSE 100 Index with 8- and 21-column exponential moving averages

It is not possible to show every single combination of box and reversal size as well as charts calculated on close or high/low. It is sufficient to say that it is likely that the moving average combinations will be different for each chart, which reinforces the view that the only way to determine which is best is to try various combinations until one suits. Although it has been suggested that exponential moving averages are best, there are a number of other ways to calculate moving averages, which you may wish to try.

As with trend lines, however, moving averages are an important enhancement to Point and Figure charts. Too often, a new student will query why one buy signal is ignored where another is taken. Using moving averages helps to answer that question.

Fine-tuning the guidelines

One of the problems in using moving averages is that once they have crossed one way, it can take a number of columns before they cross back the other way. For this reason, a sell signal cancelling a bad buy signal often occurs quite a few columns to the right of that signal. For this reason, the guidelines may be modified as follows:

If, after a valid double-top buy signal, the shorter-length average turns down, take any double-bottom sell signal.

If, after a valid double-bottom sell signal, the shorter-length average turns up, take any double-top buy signal.

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Using these additional guidelines does improve many of the signals by shifting them a few columns to the left. Doing this, however, increases the risk ofwhipsaws.

Using a single moving average

The reason two moving averages were chosen above was that the crossover of the two moving averages signals a change in trend. Once signalled, you look for the next applicable Point and Figure signal. There are those, however, who prefer to use a single moving average instead and if this is used, then it needs to be read differently.

It has already been emphasised that it is very difficult to see changes in the direction of a single moving average, which is exactly why two were used. This being the case, the trend of the single moving average should not be the alert condition. Instead, the alert comes when an X or 0 column crosses through the moving average. This is only effective and unambiguous ifused on 3-box reversal charts; I-box chart patterns do not lend themselves to the column-crossover method employed when a single moving average is used.

You will find that you need to lengthen the moving average when using one on its own. Where you may have used 3- and 5-, or 5- and 8-column with double moving averages, you will need to use 13 or 21 as a single average.

So, when a column ofXs rises above the moving average, this places you on buy alert to take the very next Point and Figure buy signal. When a column of Os falls below the moving average, you are placed on sell alert to take the next Point and Figure sell signal. In 3-box terms, therefore, any double-top buy occurring above the moving average is valid, as is any double-bottom sell that occurs below the moving average. It is important to clarify what this means.

For a double-top buy to be valid, both XS at the top of the pattern must be above the moving average. For a double-bottom sell to be valid, both Os at the bottom of the pattern must be below the moving average. This guideline will lead to some borderline cases for the simple reason that the moving average is calculated on the value of the box and plotted through the centre ofthe box. This means for an X to be above the moving average, the centre-line ofthe X must be above the moving average. In the same way for an 0 to be below, the moving average must be above the centre-line of the O.

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Chart9-12showsa50x3PointandFigureoftheFTSE 100Indexwithasingle 13-column exponential moving average. Sell signal A is valid as the double-bottom is below the moving average. Buy signal B is valid for the same reason, as are sell signals C and D, and buy signal E. The border-line cases are marked R, S, and T.

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Chart 9-1 2: 50 x 3 of the FTSE 1 00 Index with 1 3-column exponential moving average

Buy signal R is not valid because the first X in the double-top is not above the moving average, as you can see in the enlarged Chart 9- 1 3 . Buy signal S is valid because the centre­ line of both Xs in the double-top is above the moving average.

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Chart 9-1 3: Enlarged 50 x 3 of the FTSE 1 00 Index with 1 3-column exponential moving average

Buy signal T in Chart 9- 14 is also valid because both the Xs in the double-top are above the moving average.

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Chart 9-1 4: Enlarged 50 x 3 of the FTSE 1 00 I ndex with 1 3-column exponential moving average

If you find these signals too ambiguous, you will have to wait for the next double-top or bottom signal as the case may be. Furthermore it is easier to see the centre-line of an X than it is to see it of an O. If you are unsure, look left and see whether there is a larger pattern which will help you decide.

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Final word on moving averages

Moving averages are powerful tools and one of the most popular Technical Analysis tools used. Using them in conjunction with Point and Figure signals enhances the signals produced by a Point and Figure chart. It has been suggested here that you use various moving average combinations. Do not presume that one of these combinations will work in all cases. The power of a computer allows you to try and test many different combinations and you are urged to do so.

Furthermore, moving averages have been used here in isolation without the aid of 45° and subjective trend lines. Trend lines are very effective with Point and Figure charts and you are urged to incorporate them, as well as moving averages, into your Point and Figure analysis.

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Parabolic stop and reverse (SAR) on Point and Figure

When J. Welles Wilder devised the parabolic SAR, he wanted an indicator that kept you in the market, either long or short, hence the name ‘ Stop and Reverse’ . The parabolic is either bullish or bearish which makes it well-suited to Point and Figure charts, which are also either bullish or bearish.

The calculation of the parabolic may be found in Wilder’s book, New Concepts in Technical Trading Techniques. The only difference is that where Wilder used the period’s high and low in the calculation, the Point and Figure version ofthe parabolic uses the column high and low. This is logical because when any type of calculation is attempted on a Point and Figure chart, it is the number of columns which are important. Also remember that, as the column is building, the latest box is always either the high or low ofthe column.

The parabolic is like a trailing stop but, unlike a simple trailing stop, it has an acceleration factor which allows it to start some distance away from the price after the initial signal, but get closer as the trend matures. This is the ideal situation. The parabolic tightens your stops for you as the trend matures.

The parabolic, therefore, shows trends in exactly the same way that moving averages do, except they are far easier to read. This is because the traditional way to draw the parabolic is with a series of dots. The dots then swap from one side of the price action to the other as the trend changes from up to down and vice versa. In an uptrend, the moment an 0 breaks below the trailing parabolic, the parabolic jumps above the price, signalling a trend change, and the calculation is re-initiated for the downtrend.

The acceleration factor determines how ‘ quickly’ the parabolic catches up to the price. Wilder used a factor of 0.02, which continues to work well, but may need to be modified according to your requirements. The smaller the factor, the slower the parabolic is in catching up to the price. This is the equivalent of using a longer-length moving average.

Think ofthe parabolic as a switch. When the parabolic dots switch from red above the price to blue below the price, it switches you into ‘buy signal’ mode. You must then look at the Point and Figure chart and take the first buy signal you see, whether that is to close a short or open a long. When the parabolic switches from blue dots below the price to red dots above, it switches you into ‘sell signal’ mode so you must look for sell signals.

Chart 9-15 is the same 50 x 3 Point and Figure chart of the FTSE 100 Index used when moving averages were discussed. The parabolic is drawn using the standard 0.02 acceleration factor. The buy and sell signals are marked (a), (b), (c), (d), (e) and (t). As with moving averages, when the parabolic switches, you look for the next double-top buy or double­ bottom sell signal as the case may be.

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Notice that no false signals are given. Observe, too, the very early sell signal at point (e) which is 14 columns before the breakdown-column from the 1999 to 2000 top. In particular, notice the grey shaded area before (t), where the parabolic signalled an uptrend but no double-buy signal occurred to confirm it.

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Chart 9-15: 50 x 3 of the FTSE 100 Index with a 0.02 parabolic SAR

Parabolic is a less subjective way of defining trend and, hence, makes it easier to decide on which Point and Figure signals to act.

Taking earlier signals

Although it can lead to many more false signals, it is possible to take earlier signals immediately when the parabolic triggers a trend change, without waiting for a traditional Point and Figure buy or sell signal. Chart 9-16 shows the same six signals lettered (a) to (t) again, but this time taken as soon as the parabolic switches from an up series of blue dots to a down series of red dots, and vice versa. In each case the point at which the switch occurs is marked with blue or red horizontal lines labelled (a) to (t). The black arrows show the parabolic dots switching sides. When they do, you buy or sell immediately, as the case may be, without waiting for a traditional Point and Figure buy or sell signal. You can see that taking the signals on the parabolic switch does result in earlier signals but, in the majority of cases, they occur at less favourable levels.

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Chart 9-16: 50 x 3 of the FTSE 100 Index with a 0.02 parabolic SAR showing early signals

Notice that the area marked in grey in Chart 9- 1 5 , which did not produce a signal, did produce a whipsaw buy and sell. This is shown in detail in Chart 9-17 below.

Chart 9-1 7: 50 x 3 of the FTSE 1 00 Index with a 0.02 parabolic SAR showing whipsaw details

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There will, of course, be occasions when taking signals early will be beneficial. This is usually the case when the trend turnaround has been swift and sharp. The customary way to handle early signals is to commit a part of your allotted trade capital to the early signal and then commit the rest if the early signal is converted into a confirmed signal.

Parabolic on 1-box charts

The use of the parabolic is the same on I-box charts. Remember the parabolic is a trend switch. When the trend is up, you look at the Point and Figure chart for any bullish pattern and act on it accordingly. When the trend is down, you look for bearish patterns.

As you know, patterns in I -box charts are not quite as clearly defined as those in 3-box charts, so knowing whether you must look for either bullish patterns or bearish patterns makes the interpretation of the I -box chart considerably easier.

Chart 9- 1 8 is a 50 x 1 Point and Figure of the FTSE 1 00 Index. The shaded grey areas are those where you should be looking for bearish patterns and the white areas where you should be looking for bullish patterns. As you are already familiar with fulcrum and semi-catapult patterns, these have not been marked to avoid cluttering the chart. An important point is that once the mode changes from ‘look for sell signals’ to ‘look for buy signals’, you must look left to see if a larger pattern has developed, even if that means looking back into the imaginary grey (bearish) area as defined by the parabolic SAR. Most importantly, the trigger or catapult point must be in the white (bullish) area where the price is above the parabolic SAR. This is shown by bullish semi-catapult pattern A in Chart 9- 1 8, where the catapult point is in the white (bullish) area but where the pattern started in the grey (bearish) area. The converse applies when looking for sell signals. Pattern B is triggered in the grey area, although it started to form in the white area. If the pattern had formed in the white area, but

did not trigger in the grey area, it would have been ignored. There are, of course, other patterns on the chart which have not been marked.

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Chart 9-1 8: 50 x 1 of the FTSE 1 00 Index with a 0.02 parabolic SAR

I-box reversal charts and charts using high/low construction have wider congestion areas and, therefore, present a problem with the use ofthe parabolic. This is because the parabolic acceleration factor ensures that the parabolic stop ‘catches up’ to the price when the price runs sideways. Chart 9-19 overleaf is a high/low constructed chart (the Xs and Os have been reduced in size to show more history). Compare this to Chart 9- 1 5 , which is constructed using the close only. In general, there is not much change in the signals; however, notice that as the congestion areas become wider, they do induce false signals like the area marked AA, where a buy signal was given halfway through the congestion area, resulting in a sell well below it. This is an example where common sense should override any set of rules, such as the parabolic, and a stop below the black support line marked X should ensure all long positions are stopped out.

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FTSE100(IJKX)

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Chart 9-1 9: 50 x 3 (h/l) of the FTSE 1 00 Index with a 0.02 parabolic SAR

Parabolic acceleration factor

The standard parabolic acceleration factor is 0.02. Increasing the factor produces a shorter­ term parabolic, whereas decreasing it produces a longer-term. Remember, however, that you may also alter the time horizon of Point and Figure charts by varying the box size. This gives you two ways of changing your trend time horizon and you should combine the two.

Chart 9-20 shows the FTSE 100 Index 50 x 3 again, but with a 0.01 parabolic acceleration factor, which traces out the longer-term trend changes very effectively without any of the lag that would be expected by increasing moving average lengths.

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FTSE 100(UKX)

UK)(Oao Point&Fiure(cl 50)C3 ParabolicSAR0.01

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Chart 9-20: 50 x 3 of the FTSE 1 00 Index with a 0.01 parabolic acceleration factor

As you are aware, every instrument has its own characteristics. The strategy, therefore, is to decide on your box size and reversal first, then draw the standard 0.02 parabolic to see whether it has assisted you in seeing past trends. If it has not, then adjust the acceleration factor accordingly. You will find that where the chart has narrow congestion areas, the 0.02 parabolic is best and where it has wide congestion areas, the 0.01 factor is best. There is, however, no rule, other than the rule of inspection. Literally, any acceleration factor from 0.001 to 0.999 may be used, but, in reality, 0.005, 0.01, 0.02 and 0.05 are the most common.

0.02 is often the best factor to use, as the 0.25 x 3 Chart 9-2 1 of Intel Corporation. overleaf shows. The parabolic defines the trend with exceptional accuracy. Increasing the factor does not benefit the trend definition at all. The parabolic is better suited to sharp uptrends than 45° lines because the acceleration factor ensures that the parabolic curves towards the price as the trend progresses.

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Chart 9-21 : 0.25 x 3 of the Intel Corporation with a 0.02 parabolic SAR

Combining parabolics with trend lines

Although the parabolic is a stop and reverse system, you may feel that closing a long and opening a short is too severe an action. Normally longs are closed first, then shorts are only opened if there is a second opportunity to do so, or if a major trend has broken at the same time.

Determining the major trend may, therefore, be done with trend lines, where a parabolic sell above the main trend line is used to close a long and not to open a short. This emphasises the view that you should never rely on one technique when analysing Point and Figure charts; trend and pattern formation as well as techniques, such as parabolics or moving averages, should be used in conjunction with one another.

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Bollinger Bands on Point and Figure

Now that there is an acceptable method for calculating and drawing moving averages on Point and Figure charts, other techniques, such as the popular Bollinger Bands, may be drawn as well. A full analysis of Bollinger Bands cannot be given here. Readers are, therefore, encouraged to read John Bollinger’s excellent book, Bollinger on Bollinger Bands, for a full analysis ofthe technique.

Bollinger Bands are volatility bands, drawn a predefined number of standard deviations above and below a chosen moving average. With bar and line charts, either the closing price or the high and low are used to calculate the moving average and the bands; with Point and Figure, it is the centre of the column that is used instead. Bollinger used a 20-day simple moving average with 2 standard deviation bands. The reason that 2 standard deviations are used are that the Bands then contain approximately 95% of the data.33 The upper and lower bands are calculated by adding or subtracting 2 standard deviations and these lines are then plotted above and below the moving average.

In column terms, you will find that around half the suggested moving average length is better for Point and Figure charts, although it is dependent on the make-up of the Point and Figure chart itself. I -box reversal, and charts constructed with high/low data have wider congestion areas and, therefore, fewer long columns, requiring you to lengthen the moving average. Bollinger also suggests increasing or decreasing the number of standard deviations by a few decimal points when the moving average is increased or decreased. Point and Figure charts already compartmentalise the data into boxes, so altering the number of standard deviations by a few points makes no noticeable difference.

Bollinger Bands add to Point and Figure analysis in two ways. The first is that they show when the price is overbought or oversold, which a Point and Figure chart on its own cannot show. Secondly, although Point and Figure charts are very good at showing volatility by the length of the columns, Bollinger Bands enhance the chart as they show increasing or decreasing volatility by the widening or narrowing of the Bands.

Overbought or oversold

It is important to note, and Bollinger himself stresses this, that Bollinger Bands do not give buy and sell signals; they warn you when the price is overbought or oversold and whether it is behaving in a manner that confirms the trend. During strong uptrends, the price stays close to the upper Band, sometimes breaking above it. Conversely, during strong downtrends, the price remains close to the lower Band, often breaking below it. It is what the price does when it returns inside the Bands that gives you more information.

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33 Actually 1 .96 standard deviations contain 95% of the data.

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If the price breaks above the upper band, then returns inside the upper band but remains above the central moving average, this confirms the strength ofthe uptrend as shown by blue line AA in Chart 9-22 of the FTSE 1 00 Index. The chart is the standard 50 x 3 used so often before. The Bollinger Bands are based on a 13-column simple moving average with 2 standard deviation bands.

If the price breaks below the lower B and, then returns inside the lower Band but remains below the central moving average, this confirms the strength of the downtrend, shown by line BB.

fTSE 100(UKX)
UKXDai Point&Fiure(el)50×3 Mi3Bollin erBands2.0stddev

Chart 9-22: 50 x 3 of the FTSE 1 00 with 1 3-column, 2 standard deviation Bollinger Bands

You have seen already, when a single moving average was discussed, that ifthe price breaks below the moving average, it is an indication that the trend is changing from up to down and the next Point and Figure sell signal should be taken. Conversely, if the price breaks above the moving average, it is an indication that the trend is changing from down to up and the next Point and Figure buy signal should be taken. What this means, therefore, is that Bollinger Bands add an extra dimension to the use ofthe single moving average by informing you whether the trend is strong or weak and whether the price is overbought or oversold. In this respect alone, the Bands are very useful.

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Weakness in an uptrend is indicated when the price fails to reach the upper Band but has not yet crossed below the central moving average. The same applies to downtrends. If the price fails to reach the lower Band, it indicates that the downtrend is weakening.

Uncertainty is demonstrated by the price ‘bouncing’ off the upper and lower Bands within one or two columns of each other, indicating that the price is alternating between overbought and oversold. This is typical trading range action, which brings us to the second part of Bollinger analysis.

Volatility and the squeeze

Representation ofvolatility is central to Bollinger Bands. The wider the Bands are, the higher the volatility; the narrower they are, the lower the volatility. Bands will, therefore, narrow during congestion areas and widen when the price is trending. Typically, when this happens, the price starts bouncing off the upper and lower bands, indicating a trading range. This action, together with the narrowing of the Bands helps you to identify that a congestion area is developing. As you know, in Point and Figure terms, congestion areas occur during times of accumulation and distribution when the price continually changes direction, creating short columns ofXs and Os. Remember, ifthe price doesn’t move, the Point and Figure chart does not change. If the price moves up by a few boxes then down by a few boxes, it shows that no one is prepared to hold a position for long. Sometimes Point and Figure congestion areas are not that easy to see. Using Bollinger Bands to identify these areas helps with the analysis of the Point and Figure chart as a whole.

You will know already that congestion areas are wider when I-box charts or 3-box charts constructed with daily high/low are drawn. Furthermore, reducing the box size also increases the sensitivity of the chart and, therefore, exposes congestion areas.

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Chart 9-23: 50 x 3 of the FTSE 1 00 Index using highllow data with 1 3-column, 2 standard deviation Bollinger Bands

Chart 9-23 is a 50 x 3 ofthe FTSE 100 Index. It is the same box size and reversal as that in Chart 9-22, but this time it is constructed with daily high/low data instead of the close only. Notice how the Bollinger Bands converge during the congestion areas, showing volatility decreasing. The congestion area marked A is the 1 999 to 200 1 top. Without the Bollinger Bands it would have been harder to see the reduction in volatility. Notice the narrowing of the Bands in area B as well. At the time, without the assistance of the Bands, it would have been difficult to say that volatility was decreasing to such an extent.

Volatility cannot keep decreasing; it needs to revert to the mean at some stage. When the Bands come together, Bollinger calls it ‘ The Squeeze’ and suggests it may be identified when the Band width is the narrowest for 6 months. As time plays no part in Point and Figure

construction or analysis, it is not possible to use that rule. Instead, you should look at the number of boxes between the bands. If the number of boxes is around the same or less than any previous squeeze, there is a high probability of a sharp move. In the case of area B on the chart, at no time in the history of the FTSE 1 00 had there ever been only 5 boxes between the Bands! 5 boxes means 250 points or around 5% of the price at the time. As you know,

that percentage will not apply throughout the chart and so it is suggested that when volatility and the squeeze are assessed, log scale Point and Figure charts are used.

Chart 9-24 is a 1 % x 3 of the FTSE 1 00 Index calculated with high/low data. Notice the significant squeezes, circled on the chart, that occurred prior to important moves. In each case, the squeeze came down to approximately 5 boxes.

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Chart 9-28: 0.1 x 3 ofApple Computer Inc. using 5 minute data with 13-column, 2 standard deviation Bollinger Bands

Bollinger stresses that there is no single way to use and read Bollinger Bands and that different people read them in different ways. The use of Bollinger Bands on Point and Figure charts is introduced here to encourage you to explore the technique further.

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Summary

Point and Figure analysis may b e enhanced by using tools usually reserved for the analysis ofbar and line charts.

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Moving average periods (lengths) are measured by the number of Point and Figure columns.

The centre price, not the last price, in each column is used in the calculation.

The trend of the moving averages is best assessed by using two fairly short-length movmg averages.

Moving averages are not a substitute for Point and Figure signals.

Moving averages simply tell you whether to look for a Point and Figure buy or Point and Figure sell signal.

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All the techniques discussed in this chapter are alternative ways of exposing the trend, for the purpose ofenhancing the readability ofyour Point and Figure charts. They are not a substitute for pattern reading and standard Point and Figure signals. Before blindly accepting that a trend has changed because two moving averages have crossed over, or a parabolic has switched sides, always look at the underlying Point and Figure chart and the pattern that is forming. Ifthat also indicates a trend change then you should act. Ifthe pattern is not clear, then take account of the trend change signal, but wait for pattern clarification before acting.

Parabolic SAR may be used in the same way, identifying trends and informing you which Point and Figure signal to look for.

Bollinger Bands on Point and Figure demonstrate whether the price is overbought or oversold by its relative position to the bands.

Prices tend to cluster at the upper Bollinger Band in uptrends and at the lower Bollinger Bands in downtrends.

Bollinger Bands show the volatility of the Point and Figure chart, and, hence, the price.

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Squeeze points, where the column length between the bands is equal to or less than the previous squeeze, must be considered significant.

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