How to Trade - Book Review - Thomas Dorsey, Point & Figure Charting

The history of Point & Figure charting is often debated, as its exact date of origin and inventor remains unknown. Victor De Villiers and Owen Taylor stated in 1933 that the Point & Figure method is more than 60 years old. Some have accredited the method to the founding father of Technical Analysis – Charles Dow, as a matter of convenience, for his pre-eminent work on the dynamics of supply and demand driving price movement.

What is not debatable with the Point & Figure method:

• The chart’s construction excludes time altogether.  Unlike time-based charts (e.g. Candlesticks/Heikin Ashi), where a minute/day/week/month chart results in different views causing visual confusion.  This confusion is removed with P&F charts.
• Volume activity is already embedded in the Reversal counts of the P&F chart, without having to graph volume separately.  There is no need to fuss with reconciling price against volume-based TA studies.

These distinct traits give the P&F method its systematic symmetry, which enables the charting of price without the amplification of noise from time and time-based volume.

Tom Dorsey’s 20+ years of mastering the P&F method is vividly demonstrated in his book, Point & Figure Charting: The Essential Application for Forecasting and Tracking Market Prices (3rd Edition).  For a technical subject, Tom writes in an easily comprehensible style with ample graphic illustrations to reinforce learning.

There are adequate reader reviews on Amazon and Google Book Search, to help you decide if you will get the book. For those who have just started or are about to read the book, I’ve summarized the core concepts in the larger and essential chapters to help you get through them quicker.

The number on the right of the title of the chapter is the number of pages contained within that chapter. It is not the page number.  The percentages represent how much each chapter makes up of the 372 pages in total, excluding appendices. The book also comes with a CD-ROM.

Part One: Learn the Point and Figure Methodology.
Chapter 1: Introduction.  18,  4.84%.
Chapter 2: Point and Figure Chart Fundamentals.  34, 9.14%.
Chapter 3: Chart Patterns.  48, 12.90%.
Chapter 4: Foundations of Relative Strength.  38, 10.22%.
Chapter 5: Advanced Relative Strength Concepts.  36, 9.68%.
Chapter 6: Primary Market Indicators for Gauging Risk.  46, 12.37%.
Chapter 7: Secondary Market Indicators.  26, 6.99%.
Chapter 8: Sector Rotation Tools.  30, 8.06%.

Part Two: The Point and Figure Methodology—A Complete Analysis Tool.
Chapter 9: Fixed Income Indicators.  16, 4.30%.
Chapter 10: Utilizing the Exchanged Traded Fund Market.  28, 7.53%.
Chapter 11: Evaluating the Commodity Market for Opportunities.  38, 10.22%.

Part Three: Apply the Point and Figure Methodology to Your Investment Process.
Chapter 12: Portfolio Construction and Management.  10, 2.69%.

Focus on chapters 2, 3, 4 and 6, which makes up about 45% of the book. These chapters are relevant for practical trading purposes.  Here are the key points for these focus chapters, which I’m summarizing from a retail trader’s perspective.

Chapter 2: Point and Figure Chart Fundamentals. The basic tenets of a P&F chart includes: The Bullish Support Line, Bearish Resistance Line and Price Objectives which are counted in 2 ways - a Vertical Count and a Horizontal Count.  There is further refinement of using Support and Resistance Lines as Reversal points, especially when the product is trading near its 52 week High or 52 week Low. P&F charts are binary in their construction.  X representing Demand can only be in a column of Xs.  O representing Supply can only be in a column of Os. Due to this clear cut charting convention, there is no confusion if price has broken out to the upside, broken down or price has failed to breakout/breakdown and has gone into a basing pattern.

Chapter 3: Chart Patterns. Unlike Candlesticks and Heikin Ashi charts with their myriad of variations in patterns, P&F charts have a finite number of patterns. P&F charts only have one Buy Signal and 7 Breakout Confirmation patterns.  There is only one Sell Signal and 7 Breakdown Confirmation patterns. There are only 4 P&F Reversal patterns.  Lastly, there are only 5 patterns that are considered “Trap/Shakeout” patterns, typically used to warn you against entry and signal exit if you are currently in a trade. It is their symmetry that makes P&F charts a systematic and reliable tool to visualize pure price behavior.

Chapter 4: Foundations of Relative Strength. Relative Strength measures how one product outperforms/underperforms another product in comparative terms. It is nothing more than taking one price as the Numerator, divided by another price as the Denominator and multiplying the outcome by 100.  RS = (Price 1 / Price 2) x 100.  Typically, RS calculations use daily closing prices.  Though simple in its mathematical construction, Relative Strength is ingeniously powerful when it is applied not only within a sector but also across sectors. The power of Relative Strength comes into its own when it is used to compare one asset class, for e.g. Equities against Commodities, Currencies and Bonds.  As Relative Strength only uses price as the numerator and denominator in calculating a comparative measure, it overcomes the shortcomings of Fundamental metrics like the Dividend Yield, Price/Book Ratio and the Price/Cash Flow Ratio (the cousin of the P/E).  Relative Strength is not infallible.  It fails the least when benchmarked against Fundamental metrics.

Chapter 6: Primary Market Indicators for Gauging Risk. The primary Indicator for gauging market risk is the Bullish Percent Index (BPI).  The BPI measures market breadth and applies only to an Index, never a single stock.  As the BPI of that Broad Market/Sector rises above 70%, the Index becomes Over Bought. Strong Sell signals occur as the BPI rises above 70% and reverses down by a minimum of 6% - signals become stronger with confirmed Breakdown patterns below prior Resistance levels.  As the BPI of that Broad Market/Sector falls below 30%, the Index becomes Over Sold.   Strong Buy signals occur as the BPI falls below 30% and reverses up by a minimum of 6% - signals become stronger with confirmed Breakout patterns above prior Support levels. When the BPI of that Broad Market/Sector is range-bound near 50%, the BPI signals price indecision.  Dorsey Wright has constructed BPIs for all 10 sectors of the S&P 500 and also Bullish Percent Charts for non-equity asset classes including Commodities, Currencies and Fixed Income.

To conclude, as you complete chapters 2 and 4 in particular, it becomes clear that:

• You do not need the typical 4 price data points (Open, High, Low and Close) in time-based charts found in Candlestick/Heikin Ashi charts to determine if price has become directionally biased; or, if price has gone into a non-directional pattern.
• Combining time-based Technical Analysis (TA) Indicators (e.g. MACD, Oscillators, etc.) and Fundamental Analysis (FA) only concentrates the risk of placing more of your trading capital into Stocks. The TA-FA combination of methods fails to help you adequately diversify your trading risk across Equities, Commodities, Currencies and Bonds.