Point & Go Figure
First ask, What's my downside. Then calculate your potential reward.
One of the oldest bits of market wisdom around is, "Never enter a trade without knowing your downside." Just as important, however, is recognizing what your potential upside is.
One of the advantages of using point & figure charts for context is that they can define clear support and resistance levels, clear buy and sell signals, and a framework for estimating both potential upside, and potential downside.
The easiest and most popular way to measure upside, or downside as the case may be, is through the orthodox vertical price objective. It is a simple mathematical calculation that can be applied to all new point & figure signals, basically creating a risk/reward ratio comparing the price objective to the nearest sell signal, or what is deemed the most significant sell signal.
An upside price objective is calculated by counting the number of Xs to the right of the low point on the chart after a new buy signal has been generated. Let's look at an example using Johnson & Johnson (JNJ).
The first new buy signal off the chart low occurred in January 2004. the column of Xs is highlighted in green below.
Johnson & Johnson (JNJ)
(Chart courtesy Dorsey, Wright & Associates)
To calculate a price objective count the number of Xs in the column to the right of a chart low that contains a new buy signal. In this case, there are five Xs. Multiply that number by three (which is the reversal method employed since it requires a three-box move to cause a reversal), and then multiply that number by the box size being used (in this case each box represent 1 point.
Formula: Number of Xs (5) * 3 * box size (1) = 15
To determine a price objective, add that number, in this case 15, to the value of the first (lowest) X in the column that contains the buy signal. In the JNJ example, the first (lowest) X in the column used to initiate the count is 50. 15+50 = 65, so that is potential upside price objective.
A few things to notice about the JNJ price objective.
1) Since the objective was calculated, JNJ has not given a new sell signal.
2) The price objective was achieved, and even exceeded.
3) JNJ pulled back to 50 after the initial buy signal, providing a better entry point for a patient trader or investor.
4) The chart shows a clear support level at 49, 48 would have broken a triple bottom, which allows one to view the potential upside (65) relative to the first potential breakdown (48) that would allow one to determine that the position is not working as planned.
The second point is important. Price objectives are not written in stone. The price objective for JNJ was achieved, even exceeded, before the most recent pullback. This is a case where the new buy signal, and patient entry, worked out well.
There are just as many cases where the trade or investment may not work out so well. In trade management, and even investment management, this is critical because it helps a trader exit positions that are not working, and stay in positions that are working. Too often investments are nothing more than trades gone bad, the antithesis of one of Toddo's favorite maxims: Don't let your investments be trades gone bad.
While upside price objectives are a relatively simple calculation, the folks at Dorsey, Wright actually take it a step further and automatically calculate price objectives on all charts in their database, a nice feature for someone who doesn't have the time to calculate price objectives by hand.
Tomorrow we will look at how downside objectives are calculated.
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