Analyzing Supply and Demand Using Point and Figure Charts
One of the basic principles of economics is the law of supply and demand. It states that when there are more buyers than there are sellers of a given good, the price should rise. Likewise, when there are more sellers than buyers, the price should fall. In this technical analysis article, we focus on a type of chart that attempts to capture the battle between supply and demand: the point and figure chart.
Point and figure charts have been in use for over 100 years, yet they exist in relative obscurity compared to bar charts and candlesticks. Their usefulness lies in their ability to filter out market “noise”—short-term price fluctuations that occur during longer, more established trends. They differ from the more conventional charts in that they ignore the passage of time and do not take trading volume into account—they are only affected by price movements.
Figure 1 is an example of a point and figure chart for Cisco Systems, which covers daily price movements for the period from January 4, 1999, through April 31, 1999. Immediately, you should see some significant differences from other charts. First, the chart is made up of columns of X’s and O’s. X’s represent rising prices while O’s represent falling prices. Put another way, X’s represent demand and O’s supply. The movement from columns of X’s to O’s and back again creates patterns that you may use to make buy and sell decisions.
There are two key items you need to address before you can begin creating your own point and figure charts—the box size and reversal amount.
The box size is based on the scale you wish to use for a particular security or index and it represents the value given to each box (X or O) on the chart. It is the minimum price change needed to continue the trend—i.e., to add an X to the top of the column of X’s (or the minimum price decrease needed to add an O to the bottom of a column of O’s). The reason that this is even an issue is because a reversal of $3 for a $10 stock is more dramatic, on a different scale, than a $3 reversal on a $100 stock. Furthermore, since point and figure charts are used to filter out “noise” in the market, you will want to be sure that you are filtering out just enough to eliminate momentary price reversals, yet at the same time allow enough through so you can identify when a significant reversal is taking place.
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