Preface

Preface

What this book is about

This book is about Point and Figure charts; anyone wishing to practise Technical Analysis of the markets should be fully conversant with them. They may be the oldest method of charting the market in the Western world, but that does not mean they should be ignored in our modern world. On the contrary, once you understand more about them, you will wonder how you survived without them.

Who this book is for

I have written this book so that it can be used and enjoyed by all levels of reader. Newcomers may find that they do not need another text, as this book starts with the basics and covers everything that they need to get a grip of Point and Figure Charts. Expert Technical Analysts, who are familiar with Point and Figure charts, are likely to find that the book covers things they may not be aware of, at the same time reminding them of things they may have forgotten. I have tried to show as many examples as possible.

Structure of the book

The first thing you will notice about Point and Figure charts is that they look completely different from any other type of chart you may be familiar with; the main reason being that there is no time-scale along the horizontal axis. To understand why this is the case, it is essential that you read chapter 1 – Introduction to Point and Figure charts. Thereafter it is suggested that you read the book sequentially because each new chapter builds on the chapters before and assumes that you have accumulated that knowledge.

Ifyou are new to Technical Analysis

If you are new to Technical Analysis, you should read the section, Introduction to Technical Analysis, which explains what Technical Analysis is all about, and why and how charts are used. If you are an experienced Technical Analyst, you may skip the chapter and go straight to chapter 1 – Introduction to Point and Figure charts.

The Definitive Guide to Point and Figure

A summary of each chapter is given below.

Chapter 1 – Introduction to Point and Figure Charts

Chapter 1 explains the history and development of Point and Figure charts and how they came to get their name. It is essential that you read this chapter as it sets the scene and explains why Point and Figure charts look the way they do, and helps you understand more about them. You will find with this knowledge that all other aspects of Point and Figure charts become clearer.

Chapter 2 – Characteristics and Construction

Chapter 2 follows on directly from chapter I and starts by explaining the characteristics that describe a Point and Figure chart. It then explains in detail how to construct one. You may be surprised to learn that there are quite a few different ways – all valid – to construct a Point and Figure chart. Even if you have software drawing the charts for you, it is important to understand the various methods and the implications of using them. Some software, unfortunately, does not draw them correctly and unless you know what is right, you may be using charts that are incorrect without knowing it. Full details of arithmetic as well as log scale construction methods are provided, as well as the difference between using tick-by-tick data and end-of-day data.

Chapter 3 – Understanding Point and Figure Charts

Chapter 3 is about understanding Point and Figure charts and the patterns associated with them. Instead of listing dozens of theoretical patterns, you are encouraged to understand how the patterns develop and what happens when they do. There are differences in the pattern make-up depending on the construction method. Chapter 3 explains those differences and compares and contrasts them. The chapter explains how Point and Figure charts generate buy and sell signals, and when signals should be ignored. Trend lines are essential to Point and Figure analysis and a full explanation of their use is given.

Chapter 4 – Projecting Price Targets

Chapter 4 covers one ofthe unique features ofPoint and Figure charts; the ability to project price targets using both the vertical and horizontal count methods. A full explanation of the calculation, as well as where and how to apply the counts, is given. Once again, different construction methods result in different ways of calculating the targets. The implications of targets being exceeded or not achieved is explained and also how this adds to the analysis of the chart as a whole. There is a full explanation of risk-reward ratios and how they can be established on a Point and Figure chart.

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Preface

Chapter 5 – Analysing Point and Figure Charts

Chapter 5 explains how to analyse a Point and Figure chart. It explains how to approach the chart and how to decide what Point and Figure parameters to use when drawing the chart. It explains the implications of altering the parameters. You are then taken through an exhaustive step-by-step analysis of the FTSE 100 Index and the NASDAQ Composite using two construction methods. Finally, there is an explanation of how to use stops with a Point and Figure chart.

Chapter 6 – Point and Figure Charts of Indicators

Chapter 6 describes the benefits of drawing Point and Figure charts of indicators – calculated lines – such as relative strength, on-balance volume and oscillators. It explains that Point and Figure is simply a method of charting data and it should be used for drawing charts other than

just price charts.

Chapter 7 – Optimisation of Point and Figure Charts

Chapter 7 discusses the case for and against optimisation; how Point and Figure parameters may be optimised and what the benefits or disadvantages are of doing so. A number of examples of optimised parameters are given and it is shown how these can be used to assist analysi s .

Chapter 8 – Point and Figure’s Contribution to Market Breadth
Chapter 8 covers Point and Figure’s contribution to market breadth, namely, bullish percent.

It explains how the chart is calculated and how to read it.

Chapter 9 – Advanced Point and Figure Techniques

Chapter 9 covers advanced Point and Figure techniques such as the use of moving averages, Parabolic SAR and Bollinger Bands on Point and Figure charts. It explains how using these techniques can enhance the readability of the charts.

Chapter10- ChartExamples

Chapter l O is there to answer the complaint so often levelled at authors; that there are not enough real-life examples. Chapter 1 0 contains a number of chart examples from a number of markets with a brief explanation of each to help you understand how to approach a Point and Figure chart.

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The Definitive Guide to Point and Figure

Chapter 11 – Conclusion
Chapter 1 1 concludes the book with a summary of the major points made in the text.

Chapter 1 2 – References and Further Reading
There are many fine texts that preceded this one. Many have been used as references and you

are encouraged to read as many as possible.

Figures and charts in the book

Throughout the book you will see references to figures as well as charts.

Figures are diagrams I have drawn to illustrate a particular aspect of Point and Figure charts.

Charts are actual Point and Figure charts of indices, equities (stocks), exchange rates and commodities from a number of international markets.

The colour used throughout the book makes reading the charts so much easier.

The name and origin of the instrument used in any chart is not important. A chart is a chart, no matter which market and which country it has come from. When looking at the charts, try to ignore the instrument name. Do not assume that if you do not trade the particular instrument, the chart is of no use to you. Point and Figure techniques apply across all instrument types in the same way.

4

Introduction

The question I ask myself before reading a book such as this, is what qualifies the author to write on the subject?

I am not going to pretend that I started trading stocks when I was at junior school. I can’t even pretend that it was at high school; there were many more exciting things to do at that age. I confess that I did not pay my way through university from the proceeds of trading either. In fact, I graduated in 1 975 and settled down to the life of an automotive engineer, blissfully unaware that the stock market even existed. I was 27 before I became aware of financial markets, when I returned to university in Britain to take an economics degree.

Some may therefore regard me as a relative novice. I only have 25 years of Technical Analysis behind me. It was in 1979 that I was first introduced to the subject and in 1980 I bought a copy of How Charts can Help you in the Stock Market by William Jiler, which I read many times over. I tinkered with charts without really understanding too much about them, but I knew enough to tell me that this was what I wanted to do for the rest of my life.

After graduating in economics, I returned to South Africa and joined my brother who was coincidentally in partnership with a South African Technical Analyst, Tony Henfrey, publishing a Technical Analysis newsletter on gold and gold shares. It was there that I was introduced to Point and Figure charts and have been intrigued by them ever since. We had a team drawing and updating both Point and Figure charts as well as bar charts, by hand in large chart books every day. We also used basic arithmetic and exponential moving averages as well as momentum indicators, all of which were calculated by hand and logged in large journals from which the charts were drawn. It took more than half of the day to produce the charts, leaving the balance of the day for analysis. Eventually we bought a very basic computer (pre-IBM) that we used to generate some of the calculations for our hand drawn charts.

I learnt a lot about Technical Analysis and how markets worked during that time. We had a stockbroker two floors above us with a Reuters Ticker or Telex machine, as well as a number of Reuters Stockmasters. I would run up the stairs a number of times a day to record the latest prices so we could update our charts – in pencil, because the market had not yet closed – to see what the latest position was. The stockbroker was typical of the time; tea was served to anyone in reception. It was a gathering place; a place to chat about the markets. The same faces were there day after day. We called them the ‘old boys’. They sat there watching the ticker; some of them updating a few hand drawn charts. Very often, those charts were Point and Figure charts. They had been around a long time and I learned so much from them.

At the time, we also had a very good relationship with a broker on the floor of the exchange and seeing and experiencing the live open-outcry trading taught me a lot about how markets

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The Definitive Guide to Point and Figure

worked. We were able to speak directly to the floor and get a feel for what was happening. They liked the chartists because our infonnation combined with the floor intuition could give them a head start.

Commodities were big then as well, especially metals. Trading LME silver was an exhausting and very emotional experience. To be called up at 8pm, when you had a long position, only to be told that silver was nearly limit down in New York, was chilling to say the least. The decision was to either ignore the outside LME trading or try to open a contrary position in the US market. It was bracing stuff.

Our intra-day charts were mostly Point and Figure charts because they were easy to update and it didn’t matter if you missed the occasional price. Although manually updating charts tells you more about the emotions of the market than electronically drawn charts, I realised that the only way forward for the company was to computerise. The IBM PC had just been released and it seemed a good use for the computer, although not everyone thought so, and I was told that charting could never be computerised. I didn’t believe it and decided to spin off a separate company, Indexia Research, with the specific aim of computerising Technical Analysis for our internal use. Together with a brilliant computer programmer, John Johnson, we worked on the first program and, in early 1983, we saw the first chart drawn. It was a revelation. The chart took 12 seconds to draw! We were so excited that we took the rest of the day off because we couldn’t believe how quick it was. Although 1 2 seconds is laughable now, remember that to produce the same chart by hand would have taken an hour. Being able to change the periods of moving averages in seconds convinced us that we were on the right track and soon all Technical Analysis would be done by computer.

We used the software we had written for our own analysis and produced charts and advisory reports from the PC. Word soon spread that we had produced a Technical Analysis system and we started to see a demand from other market analysts for a similar program. So, we decided to give it a name, Indexia Research Market Analyser, IRMA for short, and start selling it. But how? We had no experience of producing and selling software. What about a manual? How did we stop the program from being copied? All these things crossed our minds but, being young and naIve, we forged ahead.

Our first system was written for a Gennan designed MS-DOS-based PC, the NCR DecisionMate V, mainly because it had a 640×400 full colour resolution compared to only 320 x 200 for the IBM. The problem was that we had to sell a PC as well as the software and that was not easy. There was a big demand from brokers and banks who were fitted with IBM PCs and were not prepared to go down the NCR route. So, we produced a monochrome IBM version (I refused to allow anyone to see our charts in low resolution IBM colour). Soon every broker and bank in South Africa had an Indexia program, together with a growing band of private users that quickly grew into thousands.

In 1 986, we released a new version of the program called INDEXIA II at an investment show in Johannesburg. Nothing like it had been seen before. It had many innovative features as

6

I ntroduction

well as a number of Indexia indicators I had developed, the Indexia Market Tracker being one of them. It was very successful and proved to be just what the market wanted. In order to expand the business, we opened up agencies in the UK and Australia, but neither of these markets matched the sales of South Africa. The UK, in the 1980s, was behind South Africa in terms ofTechnical Analysis and we struggled to make it acceptable to the British investor.

I eventually decided that the only way to make Indexia and Technical Analysis acceptable in the UK was to move; so John and I moved the company and our families to the UK. The strategy worked and soon we had released a more powerful version INDEXIA II Plus.

Throughout the 1 990s Indexia software was regarded as the best Technical Analysis software available and, in 2001, Indexia won the first Shares Magazine annual award for the best Investment software.

Then in 2001 I agreed that Indexia join forces with a public company, Updata plc. It was a difficult decision to make, but having weighed up all the options, I realised that together we would be more progressive; Updata’s programming resources combined with Indexia’s reputation and Technical Analysis knowledge would make a formidable team and indeed it has. As head of Technical Analysis at Updata plc I was able to design an all-new Technical Analysis program, Updata Technical Analyst, which many regard as the leading Technical Analysis software. Its compatibility with major services such as Bloomberg has brought me into contact with some of the world’s leading Technical Analysts from whom I have continued to learn.

Another book on Point and Figure?

You could be excused for asking why there is a need for yet another book on Point and Figure charts. I have read many excellent texts and there are some yet unread. This book has been over 20 years in the making for no other reason than that it was easier to put off today what could easily be accomplished tomorrow. If I had finished it 20 years ago, it would have been one of a handful. Now there are dozens. The interesting thing is that, no matter how many times I read about the same technique in different books, I pick up something new each time due to the way the author is able to articulate it. I hope that the same will apply to this book. I have consciously and sub-consciously used information I have gained from reading other books. I have listed these in the References section at the end and thank the authors for their assistance.

I am, however, disappointed that of the many fine Point and Figure books available today, none cover the original I-box reversal charts in any detail. These are where Point and Figure charts began and they still have a place today. This book goes into more depth on traditional Point and Figure charts than any other book I have read. The aim is to ensure that you understand the history, development, calculations and the analysis of Point and Figure charts. You really need these basics to fully appreciate and apply this technique. Given all the facts,

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The Definitive Guide to Point and Figure

you, as the reader, may go out and apply every technique and assess for yourself whether it is of any benefit to you. Many believe that no knowledge of the construction and make-up is required because we all have computers to draw the charts. This is wrong. If you do not understand what is behind a Point and Figure chart you should not use them.

Do not presume that this book can replace all the other fine books on Point and Figure charts. It cannot. It can only supplement them. Although I believe this to be a complete work, you will gain further knowledge by reading some or all of those listed in the References section at the back of this book.

Desert Island charts

I have often described Point and Figure charts as my ‘desert island’ charts. This has nothing to do with a special pattern I have discovered – as a student on a course once thought – but more to do with their usefulness. In the UK there is a radio program called ‘Desert Island Discs’ where celebrities nominate the songs they would most like to hear if stranded on a desert island. So just like we all have our favourite book, or our favourite song, I have my favourite chart. If I were ever shipwrecked on a desert island with only one chart to guide me through the markets, it would have to be a Point and Figure chart. No other single chart has the ability to cut through the chaff and show what is really going on.

Technical Analysis software

Although, at the start of my Technical Analysis career, I drew Point and Figure charts by hand, I no longer think it is necessary – unless of course you draw one just to ‘keep your hand in’. I believe that computers can draw them more clearly, more accurately, with more flexibility and certainly a lot more quickly. As the designer and project manager ofthe Updata Technical Analyst software, I can recommend no other. Updata Technical Analyst does what every Point and Figure analyst requires in a clear and, most importantly, accurate way. Speed and flexibility is key to good Point and Figure analysis, as you will see, and good PC software can do this so much better than an internet-based system can.

The Point and Figure charts used throughout this book are taken from Updata Technical Analyst. More information may be obtained from www.UpdataTA.com in the USA or ww.w Updata.co.uk in the rest of the world, from where you can download a trial. You will find that being able to draw and analyse charts while you are reading this book will help your understanding. With the introduction in 2004 of a version of Updata Technical Analyst that works with Bloomberg Terminal, it is used increasingly by some of the world’s leading market professionals. Indeed, some ofthe charts in this book were provided by professionals using Bloomberg data.

8

Acknowledgements and thanks

I would not be at this point in my career today without the help of many people: my wife Lynne, who has given me so much support over the years; my daughter Angelique and son Daryl, who encouraged me to finish this book; my brother Dennis, who introduced me to a career in Technical Analysis and has encouraged me through it during good times and bad; John Johnson, who was my business partner for over 20 years, and whose creative genius created the range of Indexia Technical Analysis software systems and most especially Point and Figure charts, long before Technical Analysis software was generally available for the PC; Tony Henfrey, who taught me the basics of Technical Analysis and how to understand charts; David Linton, Chief Executive of Updata pIc, who gave me a free hand to create the Technical Analysis program of my dreams without any restrictions and gave me time to complete this book; Sami Khan of Updata whose brilliant mathematical mind turned much of my theoretical ramblings into the best computerised Point and Figure charts available today, and Nigel Shaw and Andrew McKendrick who helped him to create the world’s best Technical Analysis software system; John Cameron whose advice and encouragement helped me to keep going; the many authors over the last 100 years or more, whose writings I have digested and which have helped me to write a book on Point and Figure charts; finally the thousands of nameless individuals who supported me, the Indexia Technical Analysis software and then the Updata Technical Analyst software for over 20 years, and whose suggestions I have noted, and in many cases have unashamedly used in the software and this book. Without all these people, I would not be in this very exciting business today and would certainly not have written this book.

Most especially, I would also like to thank Sami Khan, David Linton and Tony Smith for patiently and studiously reading through the text to see if it made sense and giving valuable comment and advice.

Finally any errors, omissions and plain incompetence are entirely my own.

Jeremy du Plessis CMT, FSTA Berkhamsted, United Kingdom 2005

Any comments on the book will be gratefully received at PointandFigure@updata.co.uk

Introduction

9

Introduction to Technical Analysis

In order to fully understand Point and Figure charts, it is essential that the reader understands the basics of Technical Analysis. This brief introduction simply lays the foundations of Technical Analysis and explains the philosophy behind it. If you are new to Technical Analysis, it is essential that you also read one or more ofthe excellent texts on the subject, such as Murphy or Pring listed in the References section.

Experienced readers may skip this section and go straight to chapter 1 – Introduction to Point and Figure Charts.

Technical Analysis of markets has been around for well over a hundred years, but what really popularised it was the advent of the IBM PC and the Technical Analysis software that followed in the early 1980s. This allowed private investors to start doing their own analysis and compete on equal or better terms with the professionals. Societies and associations of Technical Analysts’ gained popularity and met regularly to discuss the subject and publish journals. Most countries now have their own organisations and there is an International Federation of Technical Analysts, which holds a worldwide conference once a year. Even universities are starting to embrace Technical Analysis and offering courses, but anyone thinking that Technical Analysis is a short-cut to riches should think again; it is not. Technical Analysis is a method that requires time and effort to be spent on it to be profitable.

Technical Analysis and the ‘F’ word

Technical Analysts are not normally appreciative ofthe ‘F’ word being used in their presence, however there are some who tolerate it and indeed some who embrace it. This author believes, however, that there is no place for ‘fundamental’ analysis ifTechnical Analysis is used, but there are those who use both methods. Either way, they are very different and although this is a book on Technical Analysis, it is important to understand the difference.

Fundamental Analysts look at macroeconomic, microeconomic and business factors in order to determine the direction ofthe market and the prospects for a particular share. The objects of their research include company reports and economic statistics.

Technical Analysts, on the other hand, look at price and volume changes to deduce from these the direction ofthe market and the prospects for the price ofany instrument; the only measure that truly counts if you are an investor.

Technical Analysts argue that all these known and less known factors are reflected in the price and if good, the price will rise, and if they are bad, the price will fall. Technical Analysts argue that fundamental analysis lags the market to be of any use.

, Web sites: Society of Technical Analysts (STA) ww.w sta-uk.org , Market Technicians Association (MTA) ww.w mta.org, International Federation of Technical Analysts (IFTA) ww.w ifta.org

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The Definitive Guide to Point and Figure

There are, of course, stories that Technical Analysts love to tell. There is the one about the Technical Analyst and the Fundamental Analyst having lunch one day. Accidentally, the Fundamental Analyst knocks his steak knife off the table and it goes straight into his foot. The Technical Analyst looks at him and says, “That must have hurt, why didn’t you move your foot?” The Fundamental Analyst replies, “1 thought it would go back up again”. No matter how good the fundamentals are, a price in a strong downtrend is unlikely to reverse back up again without demand behind it.

Another is told about a broker who phones his client and says, “Hi, Bob, I have some good news and some bad news”. Bob replies, “Oh dear, give me the bad news first”. The broker says, “You know that share 1 told you to buy yesterday? Well, it has halved in price this morning”. “Oh no,” says Bob, “What’s the good news?” “The fundamentals are still good”,

replies the broker.

Well, he’s probably right. The fundamentals probably are still good because they have not had time to change. As John Maynard Keynes once remarked, when criticised for altering his position, “When the facts change, 1 change my mind. What do you do, Sir?” For a Technical Analyst, the facts are the price. Ifthe price breaks up through a price level, a Technical Analyst may recommend buying. However, if, for some reason, the price pulls back again and goes in the other direction, Technical Analysts will change their view and recommend selling – unlike the broker, who, despite the change in direction, tells his client that the fundamentals are still good. Technical Analysts are often criticised for changing their view, but in fact a speedy adaptation to the movement in the price is the strength of Technical Analysis.

What is Technical Analysis?

Technical Analysts have never been very good at explaining what Technical Analysis is, s o it is not surprising that it is often misunderstood. Technical Analysis in the Western world goes back to the 19th century, when Charles Dow, of Dow Jones fame, laid some of the foundations for the subject. Since then, its history has been well-documented, and books from the first half of the 20th century are excellent reading for anyone wishing to understand more about the subject and its rich history. So what is Technical Analysis and why is it is the best way to analyse markets?

When asked, most people will tell you that Technical Analysis is about charts, but it is likely that they don’t know why. A book by Robert Edwards and John Magee, one of the definitive Technical Analysis texts, described (Technical Analysis) as follows:

“Technical Analysis is the Science ofrecording, usually in graphicform, the actual history of trading (meaningprice changes, volumes etc.) in a certain share, or commodity etc. and then deducingfrom that pictured history, the probablefuture trend. ”

12

Introduction to Technical Analysis

The definition is correct, but it doesn’t explain what Technical Analysis actually is. It’s a bit like explaining that a car is a pile of steel, glass and rubber that gets you from A to B. A car may be made of these things, but the definition does not communicate what a car really is; a mode of transport.

Technical Analysis is the art ofrecognising repetitive shapes and patterns within a data series represented by charts. It is the understanding that these patterns are created by price changes which are in turn created by the market participants like you and me. The patterns created by the market participants repeat themselves because human nature is constant; just like fashions repeat, so market action repeats itself.

The important point to remember is that it’s people that create the price – their fear and greed, their hopes and prayers, and the opinions ofthe market participants. The price, and therefore the chart, is the weighted average sum of everyone’s feeling or opinion about a particular share, future or commodity. It’s better than an opinion poll, because everyone with the slightest interest in the share makes their mark by participating in the buying or selling thus making the price go up or down. A chart, therefore, is a study of human behaviour, and that is the key to Technical Analysis.

Technical Analysis is a bit like trying to cross the Champs Elysees in Paris. The safe way to do it is to wait on the pavement for a few people to gather. Someone will take a step offthe pavement and step back as a car rushes past. And so it will continue. Individuals test the road until the small group on the pavement becomes more powerful than the cars and start holding up the traffic. Then, and only then, will the Technical Analyst step out and walk across the road. Technical Analysts need some indicator that things are now in their favour, before they act.

But why do Technical Analysts draw charts? The reason is that they can’t interview all the market participants every day. All they can do is take the price and accept that at the end of the day – when all the ‘ fighting ‘ has stopped – the price represents the best estimate as to the value of the company in question. It is then far easier and more informative to draw a chart of this price on a day-to-day basis than simply to write down the price. A chart can show things that the numbers cannot. For example, charts can show trends (and in 90% of cases markets do trend).

So, charts represent price movement, but what causes the price to move? It’s simple. If there are more buyers than sellers, the price will go up. If there are more sellers than buyers, the price will go down. These are the simple laws of demand and supply that we all understand. The markets are driven by the constant fight between the buyers and the sellers. It has little to do with PE ratios, what a government minister has just said, or who a company’s directors are. It is the interaction of the market participants and how they feel about all the available information that drives the price.

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The Definitive Guide to Point and Figure

Trend

Trend i s vital to good Technical Analysis. There i s nothing unusual about that. You will hear economists, company analysts and accountants using the word ‘trend’ – trend in earnings, trend in the sales, trend in the exchange rate. Trends in fashion too. Anyone who has read Memoirs of Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay will have read about trends that have occurred in human behaviour, whether it is the price trend of tulip bulbs or the trend – one could say fashion – of going on the crusades. Trends do exist and are an integral part of human nature.

JamesDines,inhis 1972book,HowtheAverageInvestorcanuseTechnicalAnalysisfor Stock Profits, placed trends into four psychological phases.

1 . Cognitive or awareness stage

This is where the public are aware that a trend exists, but they are hesitant to get involved for one reason or another. It’s like the start of a new fashion trend. You see it in the street, but wouldn’t wear it yourself. You need to see confirmation that it exists and is not a one-off. You are aware that the market has been rising but, having been caught out before you are hesitant to get involved again.

2. Mobilisation stage

This is when the public start moving with the trend or the fashion and even the most hesitant get involved. Having seen the trend, they want to be part of it. They see others wearing the latest fashion and start to do so themselves. Having continually heard about profits that others are making in the market, you overcome your hesitation and get involved yourself.

3. Confirmation stage

This occurs when, having become involved, the public see confirmation that the trend exists and are now convinced by it. It’s the “things are different this time, the old rules no longer apply” stage and complacency sets in. This stage was evident in the internet boom of the late 1 990s. It’s when you have taken up the fashion yourself and see others wearing it as well. Having become involved with the market you start to make the gains that others have been making. You feel secure.

4. Equilibrium stage

This occurs when the expectations are no longer met and the trend has to retreat dramatically to bring back equilibrium again. These expectations could be profit-related. Investors used to making 20% a month become disappointed with only 10%! It’s when the fashion you have been wearing doesn’t look that good anymore and when you step out you feel like a fool.

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Introduction to Technical Analysis

During this phase, the stock market can retreat significantly, as it did in the years following the technology boom top in March 2000.

Think how these phases apply to the analogy of crossing the road. The pioneers start, the crowd follows and everyone is happy, except the motorists, who, after waiting for a while, get impatient and start moving forward to prevent the pedestrian trend from continuing.

Technical Analysts are therefore most concerned with trends and trend lines. You just have to look at any chart and you will see that prices do move in trends. Human beings are trend followers. Technical Analysts observe these trends and act when important trends are broken.

Support and resistance

In addition to prices moving in trends, Technical Analysts also look for support and resistance levels. Support occurs at a level at which the market participants believe the price will rise and, consequently, where the demand is. Resistance occurs at a level at which the market participants believe that price cannot rise further and, consequently, where the supply is. Technical Analysts don’t look for fundamental reasons why certain areas are support and resistance areas, they simply observe that they are. In fact, they occur mostly for psychological reasons. Let’s have a look at how it might work: Figure 1 shows a hypothetical price on the decline.

�cResistance �E
o

M

Figure 1 : Support and resistance

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The Definitive Guide to Point and Figure

The price is in a downtrend. It pauses, reacts back up to point A, and then falls to point B. Technical Analysts d o not reason why i t did this; i t i s simply understood that supply and demand caused the price to move in this way. At point A, buyers were not prepared to pay any more and so the price declined to B, where the buyers were prepared to start buying again.

You have to remember that the market is made up of lots of participants with differing views and objectives. Buyers who bought at point B may take profits at point C. However, there is another group who bought at point A, are pleased that the price has risen back to the same level at point C, and are pleased to get out of their position. This collective view causes a resistance level at point C and causes the price to move down from point C.

Remember, buyers at point B made a good gain when they sold at point C, and so when it gets down to point D they start buying again. This creates a support level, where buyers are prepared to take an interest again. This demand pushes the price back up again. Once again, at point E, they start selling, reinforcing the resistance level at that level. This causes the price to decline again until it reaches support at point F, where the same short-term traders, who have bought at B and D before, start buying again.

Point G is as far as the price gets again because the short-term traders have become confident that it will not go higher, and so the resistance at that level gets stronger. It declines again to point H and, once again, the buyers come back again, creating support for the price. The price bounces to point I and then falls back to point J. The same buyers who bought at point H are pleased that they now have a second chance to buy at the same price at point J, but this time, the sellers are in charge and force the price below point J. It is important to consider how the participants feel about this. Buyers had become confident buying at the same level and making a profit, so much so, that they probably were buying increasingly more each time. For the first time, they are in a losing position.

Some will sell their positions immediately, creating a selling frenzy that pushes the price down. Others will, however, hope and pray that the price will rise back to the price they paid. Point K is the point where the price has become oversold. That is, it has fallen too far too quickly, and short-term traders looking for a quick profit start buying. This forces the price back up to point L briefly, where the new buyers take a quick profit and some of the B, D, F, H and J buyers sell to break even. The move to point L is short-lived as so many sellers appear. So, the level at point L, which was a support level, now becomes a resistance level. The price falls to point M.

There is no reason why the price stops at point M. It could be at any level. It is simply a point where demand exceeds supply and the price is driven back up again. It is important to pause and consider the psychological make-up of the participants. There will be a large group who bought at the B, D, F, H and J levels and are still holding their positions. What is going through their minds is ‘if only the price can reach the price I paid, I will sell out and never buy another thing again’ ! This creates even more resistance at the L level, which is the same level as the previous support. So, when the price does eventually rise back to that level, those

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The Definitive Guide to Point and Figure

Price patterns

In addition to looking at trends, support and resistance, Technical Analysts also look for price patterns. These patterns help us to predict whether a trend has reversed or whether it will continue. They are not rigid patterns, and perhaps Technical Analysts made a mistake when they decided to give them names, like double-tops and head and shoulders, because then the uninformed take hold of them and recite them without understanding how and why they are created. These patterns are created by crowd psychology as well.

Let’s see how it happens, referring to Figure 2.

Figure 2: How price patterns are formed

The price finds a level where it starts to move up. Very few people get on the first leg up. After the first move up, profit-taking forces the price back and Group A buys. The point where Group A buys allows a trend line to be drawn from the bottom to this point. The price runs up and Group A, who are then showing a good profit, sell, causing the price to fall back again. When they think the price is at bargain levels, Group B, who missed out before, buys. The price runs back up again and Group B eventually sells for a profit and are pleased with themselves.

The price falls back to the psychological trend – the red trend line – in Figure 3. Group C, the largest group, usually small players, who have missed the whole move from the bottom, buy in the circled area. Instead of rising, however, the price continues down, breaking the uptrend line. Remember, however, that none of these participants are consciously aware that

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the trend line exists. Consider the psychological state that members of Group C are in. Their first foray into the market has left them holding a paper loss. Many will be praying that the price gets back to the level they paid so they can get out at break-even. The ‘cheapness’ of the price however attracts the attention of Group B, who notice that the price is in the same area that they had made a profit from before. Group B therefore buys as well and the price moves up again allowing a new trend line to be drawn. It is the line where there is currently demand. As the price reaches the level paid by Group C, it is held back by selling from Group C, who have just suffered the trauma of the price falling below the level they bought at. So, Group C sells to break even, placing resistance on any further up move, and the price falls back again. This allows a downtrend line to be drawn from the top. It is the line where there is currently supply. Look at Figure 3 . The price is trapped in a triangular pattern bounded by the neckline and the downtrend line. It is a point of resolve, where either the demand from buyers or supply by sellers must take the upper hand. Also notice that a head and shoulders pattern has been traced out by the antics of the various groups. There is a head and two clear shoulders supported by a neckline.

Figure 3: How price patterns are formed

Introduction to Technical Analysis

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The Definitive Guide to Point and Figure

Figure 4 shows what happens next. Instead of rising, the price falls, breaking the neckline in the circled area, indicating that the supply is greater than the demand. The price falls back and a new Group D, who have not yet participated, buy. Again the price moves up slightly, hitting the downtrend line where Group B, thankful that they can break even, sell. This selling pressure forces the price to fall again and another new group E buys. Once again, the demand, this time by Group E, drives the price back up and Group D, who have seen paper losses, use the opportunity to sell at a small loss, thankful to get out. This halts any further up movement and the price falls further until another new group F finds it cheap enough to buy. It is likely that Group F will consist of many members of Group A, who have seen the price come back to the level where they bought and made profits previously.

F i g u re 4: How price patterns are formed

The process continues in Figure 5. The price moves up and Group E, thankful to get out at break-even, sell, forcing it down again. As this happens, Group F, who can’t believe their luck, come in and support it by buying more at the same level they bought before. The price moves up again. Group F who are now aware of previous levels where the price had turned down, sell for a profit, and the cycle starts all over again.

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Introduction to Technical Analysis

Figure 5: How price patterns are formed

Notice that in constructing this scenario, two very important patterns are created, namely, a head and shoulders top and a double-bottom.

Don’t expect every scenario to play out in this form. There are thousands of permutations, but remember that patterns chartists observed 100 years ago still present themselves to this day. Why? Because people with the same habits and the same emotions are still behind the price moves. As you become more involved with charts and the technical analysis of them, so you will sub-consciously read them as if they are a picture of the emotions of the players in the market.

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The Definitive Guide to Point and Figure

Finally

The brilliant thing about Technical Analysis that makes it so much more powerful than any other analysis method is that you can change your analysis time horizon by changing the time-frame of data you use, switching to weekly, monthly or even 1 minute price changes. Try asking a Fundamental Analyst for a short-term and medium term view.

Technical Analysis is the best method of analysis because: It is based on fact (the price), not estimates.

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Technical Analysis is a vast subj ect. It is not the intention of this book to cover every aspect, but rather just the Point and Figure method.

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Real people with real emotions drive the price.

It keeps you on the right side ofthe trend – long in an uptrend and short in a downtrend.

It lets you know when you are wrong and allows you to change your mind.

It allows you to change your analysis time horizon by changing the time-frame of the chart.

Emotion – the Analyst’s greatest enemy

Without doubt, the greatest cause of bad decisions is emotion and, unfortunately like everyone else, Technical Analysts are subj ect to emotion when making their decisions. How many times have you spent an hour deciding which share to buy, only to be told that the fundamentals are poor? You change your mind about buying, only to see the price rise in the weeks following. How many times have you decided to sell your shares and then seen a glowing report in the newspapers predicting on ongoing bull run? You decide not to sell and, within days, the price falls dramatically.

These are the sorts of emotions that any investor is subjected to constantly. If you are a Technical Analyst in the corporate world, you may have additional pressure from your superiors who are not believers in Technical Analysis. Your advice may therefore be unpopular. Stick to your guns, however much pressure you get. In the end, it will pay off – you will be right and they will be wrong. Above all, do not listen to market gossip and rumour. So often, rumours are started by those who have bought into a share and then encourage the price to rise by spreading stories on how good the share is.

Finally, trading, and investing, isn’t easy. If it were, it wouldn’t be profitable.