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Back to Basics: Part II


This is like Holywood Squares, but for stocks!


Editor's Note: This is a reprint of a previous article. Illustrations are courtesy of Dorsey, Wright & Associates.

This continues Part I of Back to Basics, which can be found here.

Below is a simple flow chart that is used to update a point and figure chart each day.

Here is how we utilize the flow chart.

First Flow Chart Question: "Continue Current Column with X or O?"

Whichever column the chart is in, you will remain in that column as long as the stock continues moving in that direction. If the chart is currently in a column of Xs your first question is, "Did the stock rise one full box or more on the chart?". If it did move one full box, then you record that move by adding another X to the column. You are now done updating that chart for the day. That's it.

I still chart some stocks by hand for a number of reasons. One, it gives me a feel for what the market is doing internally. Two, it forces me to pay attention to sector rotation and helps me make sense of what the sector relative strength indicators I use are saying. I used to chart over 250 stocks by hand in about 30 minutes so it's not as time consuming as you might think.

As mentioned above, when charting you are concerned with the price which causes the chart to continue in the current column. In other words we are establishing an action point. If the chart is in a column of Xs, you are looking at the high price of the day, rounding down to the next whole number. If the chart is in a column of Os, you are looking at the low price of the day, rounding up to the next whole number. Let's look at a real example:

A stock has a high of 28.67. For charting we would read this as 28 since we are dealing with one-point per box increments. It is important to note that even a high of 28.99 would not be charted at 29. It must be 29 or above to get a mark in the 29 box because a high of 28.67 is not 29.

28 X 28.67 is not high enough
27 X to mark the 29 box.
26 X
25 X

When looking at the low, you go up to the next whole number. Using the same example, a stock has a low of 28.67. You would read this as a low of 29. Again, even if the low were 28.01, we would not be able to mark the 28 box because 28.01 is not 28.

32 O
31 O
30 O
29 O 28.67 is not low enough
28 to mark the 28 box.

Second Flow Chart Question: "Does the Stock Reverse Columns on Chart?"

If the answer to the first flow chart question was "no", then we must determine whether the chart reverses direction thus changing columns. We use a three-box reversal method to determine a reversal.

Three Box Reversal Method:
The price action of a stock is marked by two different columns, by Xs for the price moving up and Os for the price moving down. In other words, Xs are for demand and Os are for supply. To move from one column to the next, from Xs to Os or Os to Xs, point and figure charts require a three-box reversal. The stock must be able to move three boxes before it can change columns. If a stock is in Xs at $25 then it must fall 3 boxes to reverse into a column of Os. This would be $3 since the scale of the chart at $25 is $1 per box and it must reverse by three.

If the stock does not meet the criteria to reverse (described above) then there is not action on the chart for that day. Unlike a bar chart, a point and figure chart won't necessarily make a movement every day. If the price action of the trading day does not continue the chart in its current direction (flow chart question 1) or change columns (flow chart question 2), no mark is made on the chart.

PnF Chart Examples:
Here I want to demonstrate how a chart builds over a period of trading days.

Beginning Chart
High 47.63 Low 43.25
The top X is at the 46 level.

The first thing to determine is whether the stock traded as high as 47 to add another X. It has to be 47 even, not 46.999 but 47. Looking at the trade information (High 47.63, Low 43.25) it did trade as high as 47 so we can add another X to the column. That is all to be done for the day.

Next Trading Day
High 47.975 Low 43

Each day is the same process. You look at the high and low to determine if you can continue in the same column or if you have enough for a three box reversal. The high needed to add another X would be 48, but the high was only 47.975, not enough. So now you look to see if it moved low enough for a three box reversal at 44.

The low was 43, so yes, it is enough for the three box reversal. In fact it adds four boxes (Os). Understand that you don't just add three boxes for a reversal and stop. Once the action point, in this case 44, is hit, you add as many boxes as necessary to chart the low of the day.

Next Trading Day
High 50.12 Low 41.97
We are now in a column of Os so we look first to see if the stock trades low enough to add another O. If it does an O is added no matter how high the stock trades. The stock managed to add another O to the chart because it traded at a low of 41.97 filling the 42 box. We do nothing with the move to 50.12 because we always continue in the column we are in until we can do so no longer.

Next Trading Day
High 50.50 Low 41.45
Again the same procedure. We look to see if the stock traded to 41 to add another O and if not did it trade high enough for a three box reversal up.

Even though it traded into the 41 range it did not hit 41 exactly, so therefore no additional O.

Now we check if it traded high enough for a three box reversal up into Xs at 45, and it did, it traded as high as the 50 box so we mark the appropriate boxes.

No positions in stocks mentioned.

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