The method of trading called point and figure is a really effective trading system for trading breakouts. In this article I will explain the basic mechanics of this trading system as it was invented. Even if you have already heard about point and figure before, I’m sure this article will give you new insights and ideas. If you haven’t ever heard of point and figure, or P&F in short, than you will get an understanding of this method, and then find out how to learn more and put it into use.
First of all - Point and figure is both a charting method and a trading system. The charts are quite different to candlestick charts or OHLC-bar charts that you are probably familiar with. And somewhat like candlestick charts, the chart itself is a complete trading system once you have learned to master the method. Candlestick trader look for particular patterns in their charts, and as you will see, so do we. But the P&F charts are much easier to start using. We will trade patterns that are found in the P&F charts, like the triple top patterns for breakouts or the reversal pattern for counter trend trading.
When you use candlestick charts you probably know that the price action can get very complex. Many traders therefore use various indicator on top of their charts to filter out some of the “noise”. This works for some but, as you probably realize, not for all. Luckily the point and figure charts offer a better way of filtering out the market noise, or the messy price movements, that feel like they were designed to make you place losing trades.
In such a noisy candlestick chart it is very difficult to find exact price points where you could have gotten into a long trade at the bottom, or where you could actually enter on the break out. In point and figure the entry signals are instead quite obvious. After reading up a little on P&F you will be able to enter your trades at exactly the same price as the true professionals, and exit your trades at exactly the same price as well.
You might be thinking that these are new type of charts. But the opposite is true. These charts with these X's and O's originated from a time back in the 1800s. The method was probably used on the so called curb markets earlier, but it was with the advent of the exchanges having floor traders that the method was really crafted into what it would become.
These floor traders, or pit traders, were speculating with both clients capital and their own money in the markets. They would need a way to follow the prices systematically while they were watching the intraday price go all over the place. During that time they didn’t have charts to look at during the day, so they had to either memorize important price levels, or find a quick way to make notes of the significant price action.
Many of the floor traders are still using this idea even today. While working for brokerages they will trade their own accounts as well, and as you can understand, these guys cannot sit down to watch a chart during the trading session. You have seen these guys standing in the trading pit, showing gestures with their hands, and trying to close orders for their customers. It is quite the hectic environment and not for the faint hearted.
So, these guys are on the floor trading during the entire day, and they have their own accounts that they trade at the same time. Their primary business is of course to fill orders for other brokers who gets phone calls or electronic orders from their clients and puts in the order on the trading floor. For example to go long 100 contracts if the price hits a particular point. Now at the same time they have their own trading account and what they would do is to have a little notebook or index card in his in his front left pocket and then scribble down small symbols that the significant price move, if let’s say the price moves up 25 cents or 50cents. He will not have time to write down every price change, and neither does that matter either, as it is the significant price points that are of importance to break out traders.
This is a simple method. Draw a little X when price went up another 50 cents, write another X on the on the paper as price went went up another 50 cents. And so on. And when the market came down he would write O’s in another column. A new O for each 50 cent that the market would move down. This way he is able to keep track of the direction of price going up and down.
You realize that he is not able to or does not have time to draw candlestick charts during the day, nor does he have access to a computer or possibility to go look at a terminal to look at the price chart, so he's just simply scribbling X's as the price goes up X's going up and then if the market starts going down he starts drawing a column of O's going down. This is where the point and figure system started, as these floor traders needed a really simple way to trade breakouts
As S's went up and then the O's came down, and then when the X's went back up again he would be able to see a breakout. The simple hand made charts gave real clear breakout signals to trade. Today we don’t need to keep hand made records as we have online point and figure charts.