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Back to Basics: Part IV


I get it! It's like Hollywood Squares, but for Wall Street!


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

I thought I'd continue with the final article in our series of point and figure basics. For those of you arriving late to the party, here are lessons one, two and three.

In lesson three we looked at the most basic point and figure buy and sell signals; the double top and the double bottom. Today we're going to look at a few more complex patterns.

Triple Top
The triple top is exactly what the name suggests - a chart pattern that rises to a certain price level three times, except in the world of point & figure analysis it is a good thing, not a bad thing. The first two times the stock visits that level, it is repelled by sellers. The third time the stock rises to that level, it forms the triple top. The buy signal is given when the stock exceeds the level that previously caused the stock to reverse down.

There are many reasons why a stock will encounter supply at certain levels. Think back to a time when you bought a stock thinking it was at a bottom or at least an opportune price level to buy. Instead of rising, the stock immediately declined. We have all had experiences like that. The thought that may have crossed your mind as you saw the stock lose value was that if the stock got back to even you were getting out! This is a perfectly normal human reaction. When you place that order to get out at your break-even point, you are in essence creating supply at that level. If more sellers are willing to sell their stock at that level than buyers are willing to buy, the stock will decline. The only way we know whether the selling pressure has been exhausted at a particular level is if the stock is able to exceed that price. If the stock is repelled again, the sellers are still there.

An old technical analysis saw is that the degree to which a stock will rise is in exact proportion to the time the stock took in preparation for that move. In other words, the wider the base from which a stock breaks out the higher the stock will rise. This is one of the reasons we consider the triple top break a stronger pattern than the double top.

Triple Bottom
The triple bottom sell signal is characterized by a stock falling to an area of support three times. The first two times the stock holds and reverses up. The third time there is not enough demand to cause the chart to reverse and instead it exceeds the two previous bottoms giving the triple bottom sell signal.

The triple bottom sell signal simply suggests that the risk in that position has increased. Whether an investor chooses to do anything about the signal or not, she should at least be aware of it. If the investor does nothing other than increase her awareness of a potential decline, she is far ahead of the investor who holds the same position without any warning.

The Bullish and Bearish Catapult Formation
The Bullish Catapult is a combination of the triple top buy signal and the double top buy signal. The catapult is created when a stock gives a triple top buy signal that is followed by a pullback producing a higher bottom. Following the pullback, demand regains control and the stock reverses back up and gives a double top buy signal. The charts below depict a Bullish Catapult formation.

First, the triple top...then the double top...then the double top break...

then the completed bullish catapult formation.

Notice the triple top buy signal followed by the pullback into a column of Os and how the column produces a higher bottom. The resumption of trend completes the Catapult by giving a double top buy signal. The opposite of the Bullish Catapult is the Bearish Catapult, which is simply a triple bottom followed by a double bottom.

The Triangle formation is easily identified by the higher bottoms and lower tops. This sounds a little strange but what it illustrates is that the battle between supply and demand is a bit confused.

The formation of the triangle occurs when there is no clear winner in the battle between supply and demand. As the lower tops and higher bottoms develop the chart comes to a point creating the triangle look of the pattern. When the chart comes to a point either supply or demand will have to gain control and either a double top break or a double bottom break will be given.

Triangle Formation

A break to the upside designates a bullish triangle and a break to the downside designates a bearish triangle. Triangles that occur in the larger context of a positive trend tend to break to the upside, while triangles that occur in the larger context of a negative trend tend to break to the downside.

Bullish triangle with upside break.

Bearish triangle with downside break.

There is a tendency for those who are new to point & figure charts to become "pattern focused" to the exclusion of the other considerations that go into solid analysis. Those other considerations include the overall context in which the pattern appears. Is the primary trend positive or negative? Did the pattern occur below the 200-day moving average or above? Is the stock exhibiting positive relative strength or negative? Pattern identification is important, but in my opinion it is a secondary factor in a successful top down approach that begins with market analysis, moves to sector analysis, and then proceeds to stock analysis.

I am often asked why more people don't use point and figure charts. The answer, I believe, is that they are too simple. If the first rule of medicine is "first, do no harm," the first rule of Wall Street is "when in doubt, obfuscate." From my admittedly cynical perspective, the path to profits by those with an interest in peddling Wall Street analysis and research lies not with successful forecasting techniques, but with the sales of successfully obfuscated forecasting techniques. Even today it is not uncommon for analysis and research to be marketed with the implicit notion that it is worthwhile simply because it is nearly impossible to understand.

Despite what you have been taught, the only thing that determines price movement of securities is the same thing that determines the price movement of milk, gasoline, or telephone handsets - supply and demand. That's it. If you can understand which of these two forces is in control at any given time, then you are way ahead of the game.

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