I began a series late in December called The 12 Days of Christmas. These are expanded versions of concepts from the video on our website called We Are Not Your Old Stock Broker. So far we have discussed the need for Tactical Management, why we use Technical Analysis and how our investment process is based on the fundamental law of supply and demand. So today, we will continue the series with a deep dive into Point and Figure charting.
Charles Dow, founder of the Wall Street Journal, was the first one to popularize the Point & Figure methodology. (Granted, it wasn't called Point & Figure back then but that's beside the point.) Although a fundamentalist at heart, he also appreciated understanding the supply and demand relationship present in securities’ prices. By plotting price movement on a simple graph, he could identify several characteristics of a stock. In this example, notice that each time it rallies, it moves a little higher than the previous time, an indication that demand is getting stronger. At the same time, the pullbacks don't fall quite as far as the previous pullback, telling us that supply is getting weaker.
Ultimately, that is what we want to see in a stock or ETF we own – demand getting strongER and supply getting weaker. Notice also the formation in blue. Think back to geometry class and what does this look like – a square? A trapezoid? It looks like a triangle pattern. You’ve just read your first Point & Figure chart. There are 13 patterns in all and the bullish triangle is one of them.
While there have been minor cosmetic changes to the charts over time, the process remains the same. This is a modern-day Point & Figure chart of Caterpillar, Inc. CAT. The prices have moved to the vertical axis and notice Xs are used to record increasing prices (demand) while Os represent decreasing prices (supply). As prices fluctuate, we use alternating columns to represent that movement. A minimum of three Xs or three Os is required to make a new column, as any price movement less than that is considered normal market “noise.”
Unlike other charting methods, time is of little importance on a Point & Figure chart. Changes are made to the chart only when there is a significant enough change in price to merit a new X or O. This means the chart could remain unchanged for several days, weeks, or even years if a price remains steady. Years are plotted horizontally along the bottom of the chart, and the numbers and letters included in the chart (aside from Xs and Os) can be used to reference the month in which the chart activity occurred. For example, a “1” would indicate the first action on the chart in the month of January, “2” would be February, “3” would be March, etc. We use “A” for October, “B” for November, and “C” for December only because we are limited to one character per box.
Ultimately, a Point & Figure Chart provides a logical, organized way to visual price data. In this example, we can clearly identify a positive long term trend of higher prices (increasing demand) for Caterpillar, Inc. CAT. The positive trend line in red is referred to as the “Bullish Support Line.”
Although there are a number of chart patterns that you can track through the Point & Figure Methodology, they are all simply variations of these two most basic patterns, which are used to help us measure whether supply or demand is in control on the chart.
The Double Top (shown on the left) is the most basic “buy” signal that can occur on a chart. It is characterized by a column of Xs (representing demand) exceeding the previous column of Xs. In the example, we see the buy signal is given at $35, where the double top breaks above the previous column of Xs. This pattern tells us that demand is in control, as buying pressure has carried the price higher than the previous rally.
Conversely, the Double Bottom is the most basic “sell” signal, and tells us supply is in control. It is characterized by a column of Os (representing supply) falling below the previous column of Os. In the chart on the right, we see a Double Bottom completed at $41, telling us that there are ultimately more sellers than buyers willing to buy on this pullback compared to the previous one.
From the genesis of the Point & Figure methodology, Charles Dow found that when he plotted the price of a stock on a chart, patterns would develop; more importantly, those patterns had a tendency to repeat themselves. Some patterns had a tendency to lead toward higher prices, while others more likely lead to lower prices. The basis of the Point & Figure methodology are the simple double top and double bottom formations (discussed above), the most rudimentary buy and sell signals, respectively. In total there are 11 different patterns that we follow and the identification of these patterns can be an integral part of any trader’s or investor's evaluation process.
Maybe you will not find these patterns as interesting as we do, but the Point and Figure methodology forms the basis for the tools we use in your advisory accounts to help prevent large losses.
Until next time, cheers!