This article is part two of the Wyckoff Method analysis series. Click here for part 1
One of the most important prerequisites to trading is deciding what the price targets should be for both long investments and shorts. Traders who fail to predetermine optimal price levels often find themselves irrationally chasing prices which can lead them to hold on to security too long or short compared to what proper analysis would estimate. Consequently, Richard Wyckoff adopted the process of utilizing the horizontal point-and-figure charts to determine cause and effect relationships between price movements and security values.
These charts are designed to filter out insignificant price movements, and, since time is not a factor when plotting these charts, support and resistance is much easier to identify.
The process of analyzing securities using the P&F analysis works as follows:
To begin, one must select an appropriate bar and P&F chart. Most charts follow the open/close or high/low charts. Those charting with P&F are most concerned about the overall movement within a period, rather than focusing on minute shifts in price. Looking at a larger picture allows traders to better understand supply-demand movements.
To evaluate the P&F chart movements across an axis of time, traders must establish what they are going to consider as a unit of movement. The units could be equivalent to 50 or 100 bps, or whatever the trader considers being the best indicator of price movement action. With P&F charts, there are no axes for time, the only price.
When prices rise during the period, a trader should plot an X, and when prices fall, they should print O’s.
Let’s go through an example to further understand the process of P&F charting…
Say one is charting a stock that is trading at $10.00 with a $1.00 movement as one unit. If the stock closes up to $11.00, the chartist would plot an X in the column corresponding to the $11.00. Typically, reversals are charted only when movements represent 3 units ($3.00 in this case). One can only plot an X in the next column following the reversal if the stock increases more than the 3 units.
Besides being helpful to analyze support and resistance lines, they are helpful to identify ascending and descending trendlines, in order to time one’s trade with the correct breakout time of the stock.
Applying P&F charts to your strategy:
Reading P&F charts are some of the best ways to gauge supply and demand for securities. Experts conclude that when a stock increases by 3 X, the large demand has overtaken the supply, and when there are three O’s, the supply has overtaken the demand.
Below are examples of how one can use P&F charts to observe patterns:
Imagine taken from trendsoft.com
Overall, P&F charts are extremely valuable tools for investors looking to find chart patterns on longer time scales. While large reversal swings may take a long time to form, it is important to note that these charts should only be utilized by longer-term traders, rather than traders looking to hold the security for short periods of time. Wyckoff recommends using this method to identify the supply-demand patterns of the stock, which are necessary as one of Wyckoff’s laws to determine the price trends of the stock.
This is the third part of the Wyckoff Method analysis series. Click here for part 3