Stock charts are an easy way to keep track of a stock’s price. However, there is more than one way to plot a stock’s price and each method affords a different perspective on the stock’s price history. One of our personal favorites is the point & figure chart, which eliminates the passage of time from the equation. This installment of Technically Speaking will discuss this unique charting method.
One of the basic principles of economics is the law of supply and demand, which states that when there are more buyers than sellers, prices should rise. Likewise, when sellers outnumber buyers, prices tend to fall.
Point & figure charts attempt to capture the struggle between supply and demand. At the same time, they are able to filter out market “noise”—short-term price fluctuations that take place during longer, more established trends. Point & figure charts do this by focusing only on “significant” price movements.
While both charts represent approximately two years of daily trading, the two charts look quite different. Looking at Figure 1, we see that the point & figure chart consists of columns of X’s and O’s. A column of X’s indicates rising prices (uptrend) while a column of O’s means that prices are falling (downtrend).
As we mentioned earlier, point & figure charts only capture “significant” price moves. Each X and O on a point & figure chart occupies a “box” on the chart. The box size defines the amount by which the stock price needs to move up in order for an X to be added above the top of the current column of X’s (or the amount by which the price needs to move down in order for an O to be added below the bottom of the current column of O’s). Typically, box sizes vary depending on the share price; here are the breakdowns commonly used:
For example, if we are looking at a stock currently in an uptrend (column of X’s) and currently trading at $50, we would only draw a new X at the top of the current column if the price increased by at least $1 (one box). If the stock price does not increase by at least $1 (and does not fall by more than the reversal amount, which we will discuss shortly), we do nothing.
You can adjust the box size to make the chart more or less sensitive to price movements. The larger the box size, the larger the price movement needed to draw a new X or O in the current column. In other words, the larger the box, the less responsive the chart is to price movement.
The other important element of point & figure charts is the reversal amount. This determines the amount (number of boxes) by which the stock price needs to move in the opposite direction of the current column—down if in a column of X’s or up if in a column in O’s—before a reversal occurs. When a reversal takes place, we start a new column next to the previous column, moving in the opposite direction.
The most common reversal amount used is the three-box reversal. In this case, if we are in a column of X’s (uptrend) and the price falls three boxes from the highest X in the column, we would shift to a column of O’s, signifying a reversal has taken place. Alternatively, if we are in a downtrend represented by a column of O’s, a reversal would occur if the price rises by three or more boxes above the lowest O in the column. If the box size is $1, a reversal would take place every time the price moves up $3 in a column of O’s or down $3 in a column of X’s.
Just as with box size, we can adjust the reversal amount to make the chart more or less responsive to price action. The smaller the reversal amount, the more frequent will be the shifts from columns of X’s to columns of O’s and vice versa.
As we mentioned, point & figure charts do not mark time in a linear fashion. Depending on the price movement, a single column on a point & figure chart can represent a single day, week, month, or even longer. However, there is a way to indicate time on a point & figure chart.
Referring back to Figure 1 for Norfolk Southern, you may notice that some of the X’s and O’s have been replaced by numbers or letters. These numbers and letters are used as monthly indicators and allow you to get a general idea of when the price movements took place. The numbers one through nine correspond to the months January through September and A, B, and C represent October, November and December, respectively.
One way in which point & figure charts can be useful is that they allow you (in our opinion) to more easily identify points of support and resistance. The concepts of support and resistance are explained in the Technically Speaking column in the Fourth Quarter 2009 issue of Computerized Investing.
Support levels represent the price at which the majority of investors feel that prices will move higher. As prices decline, there comes a point where demand becomes sufficient enough to stop the downward trend in prices. When looking at a point & figure chart, support levels arise whenever you see a horizontal row of O’s marking the bottom of their respective columns.
Looking at Figure 1, we marked two support levels with blue dashed horizontal lines. The first developed between December 2008 and January 2009, when the price of Norfolk Southern fell to around $42. On three occasions over this period the price tested this support level only to rebound higher. The fourth time, however, the price broke through the support and eventually reached an intermediate low price around $33. Roughly two months later, NSC reached a two-year low around $26 and began a steady upward move. Over the period from April 2009 to June 2009, the price tested a new support level around $34.This time, however, the support held and the stock began making new highs.
Resistance levels mark the point where sellers outnumber buyers and the previous upward price trend comes to an end. You can find resistance levels on a point & figure chart by looking for a horizontal row of X’s marking the top of their respective columns.
In Figure 1, we marked two resistance levels with red dashed horizontal lines. The first developed over October and November of 2008, where the price topped out around $59 on two occasions. This was actually the last time the price of Norfolk Southern stock was that high. It will be curious to see if this serves as a resistance level should the price reach that point again in the future.
More recently, the price met resistance around $49 over the period from September to October 2009. On three occasions, the price rose to this level only to be turned back. Eventually, the price penetrated this resistance in November. However, in this example old resistance did not become new support, as the price eventually slipped back below $49.
In recent weeks, the stock’s price has straddled this level, and only time will tell whether this will become a reliable level of support or resistance.