Options Trading | Point and Figure | Relative Strength


Time Embedded in a Price Chart Simply Confuses

What is the logic for recording price, when it does not move for a given unit of time? 

While price takes time to move, time alone does not move price. 

❑  A Reward:Risk Ratio remains valid on price alone without time in the calculation. 

❑  A Reversal point can be based on price alone, independent of time.

❑  Elasticity of price within a minute/day/week/month (how wide or narrow the trading range becomes) is a function of the demand & supply for calls and puts, driven by the amount of open interest. Price elasticity is not determined by "popular"/"special" patterns in time-based charts (Bar/Candlestick/Heikin Ashi).

Embedding time with price, two characteristically different variables – as one statistic –  dilutes the intensity of price and confuses the observation of price. See thumbnail on the right.

❑  Bar and Candlestick charts suffer frequent "fakeouts" (signal failures, instead of real breakouts and warning of true traps) in addition to whipsaws. 

 

For options, the only element of time worth focusing on  – especially for a beginner to intermediate retail trader who typically uses ATM and OTM options  –   is Theta (time decay/premium), not to be confused with the unit of time (minute/day/week) in a bar/candlestick chart.

What type of chart retains pure price data and excludes time?  A Point & Figure chart.

The more commonly known merits of using Point & Figure (P&F or PnF) charts compared to bar or candlestick charts, is because P&F charts:

❑  Eliminate insignificant price movements (“noise”). 

❑  Remove misleading effects of time on price. Especially, in Overbought/Oversold conditions, time amplifies the noise.

❑  Identify obvious support/resistance levels. 

❑  Make trend line recognition and  range setting indisputable. 

❑  Concentrate only on the essential longer–term price trends.

❑  Calculate Price Targets purely on price alone.

❑  Records price reversals by construction – volume activity is already embedded in the reversal counts without having to graph volume separately.

One lesser known use of P&F charts; but, absolutely critical measure of analysing pure price–performance is combining P&F charting with Relative Strength.  Do not confuse Relative Strength with the technical indicator “RSI”. The RSI tries to predict direction by weighting the advances and declines of price movement over a given time period.  It suffers time confusion, as with any time–based indicator. RS measures the intensity of price alone, irrespective of direction and without time. They are different, without similarities.

The Home Options Trading process combines P&F with Relative Strength to separate price outperformers from under–performers; then, trade the outperformers/under–performers based on their respectively unique but still consistent criteria to positively impact the portfolio's P/L.
What is Relative Strength (RS)?
Suprisingly, it’s mathematical construction is very simple. It is nothing more than taking one price as the Numerator, divided by another price as the Denominator, then multiplied by 100.
RS = (Price 1 / Price 2) x 100.  Typically, RS calculations use daily closing prices.
Though simple in its construction, RS is ingeniously powerful when it is applied not only within a sector; but, across sectors and between asset classes.
Let’s start of within a sector.  For example, if you choose 2 semiconductor stocks trading at different prices, how do you know if one stock is outperforming the other in the same sector, when the 2 stocks have price changes at different rates and the sector’s price is also changing?
                                         Price1 RS#1  Price2 RS#2
Numerator1: BRCM 33.15 7.33  33.80 7.23
Numerator2: TSM 9.91 2.19  13.43 2.87
Common Denominator: SOX  452.24 467.81
SOX = Semiconductor Sector Index, trades up from 452.24 to 467.81.
BRCM's price rises from 33.15 to 33.80 and TSM's price also rises from 9.91 to 13.43
Simply because BRCM is a larger stock, does that mean it benefits from the SOX trading up? No, the RS reading  (RS1 compared to RS2) tells us, BRCM has weakened against TSM.
BRCM’s RS#1 = (33.15/452.24) x 100 = 7.33. BRCM's RS#2 = (33.80/467.81) x 100 = 7.23
TSM’s RS#1 = (9.91/452.24) x 100 = 2.19.  TSM's RS#2 = (13.43/467.81) x 100 = 2.87.
RS confirmed TSM as the outperformer.  RS is constructed on pure price rules. Especially, if you use an Index as the denominator, it is a much more durable benchmark to filter out insignificant noise and is much less sensitive to fluctuations, compared to any “magical” TA indicator that only evaluates a single underlying found in time-based charts.
Compare One Sector or Asset Class against Others
Numerator 1 can be any Index of the 10 Sectors (e.g. BKX – Financials) compared against Numerator 2 of any of the other 10 Sectors (e.g. UTY – Utilities) with the Common Denominator being the S&P500 (SPX). Up till Numerator 10 being the 10th sector of the SPX.
For Sectors, the RS may confirm heavier exposure to a particular Sector that is not a “hot” sector in the news. Forget the noise in the news, “listen” to the RS. Institutional money is rebalancing and reconstituting their portfolios by rotating out of sectors and into others, independent of what goes on in the news. If news cannot be translated into tradeable information, ignore it.  Besides, there are only 10 defined sectors that make up the S&P500 – money has to move between them; or, out of the sectors (i.e. away  from equities) into the other asset classes.  Stop paying for “magical” indicators and blackbox “first to know” services.
The RS method can be extended to compare Bonds, Sector Indexes, Currency ETFs and Commodities – any asset class against other asset classes. In practical terms, rank any ticker against any other ticker in your portfolio – this is the optimal way to use RS.
RS as a measure can be used independent of P&F charts. There is only one firm specializing in RS scans for trades: www.dorseywright.com. However, as RS is a price-centric measure, it is only logical that it is combined with P&F’s pure price charting. The synergy results in the most robust and reliable method of sorting out price outperformance from underperformance.
It is imperative to separate outperformers against underperformers amongst the underlying products, well before an option trade is constructed around the identified opportunity.
Once the trade is in play, use RS on an ongoing basis to revalue the strength of outperformers and weakness of underperformers, checking that rankings remain as initially chosen; or, if their relative price-performance in the portfolio shifts. Shifts signal the need to evaluate rebalancing the cash allocation within your portfolio across asset classes other than equities.
Together with Volatility, use RS to decide the proportion of long positions in outperformers to short positions in underperformers, in your portfolio. Remove the emotion in your choices.
Trading within the Sweet Spot with Relative Strength and Bullish Price Indexes

Bullish Percent Indexes (BPI) are calculated for a group of stocks and not a single stock. This makes them ideal to be used in tandem with trading Sector Indexes. The BPI is not about price but percentage changes to move a P&F box or shift columns. This why it is called a Bullish PERCENT Index.  The underlying product that you trade is still the Sector Index.  To avoid the risk of being in an unfavoured sector or not being in a favoured sector, as institutional money shifts between sectors, it is useful to track when the BPI of an entire sector is OverBought (OB) or OverSold (OS). 

Price of Sector Index can become erratic as its corresponding BPI is near OB/OS conditions, affecting the RS reading of a sector.

❑  For Indexes, levels  above 70% are OverBought and levels below 30% are OverSold. Each box in a BPI Index, is scaled at a net change size of 2%.

❑  For BPI charts, as the areas above 70% and area below 30% is taken out of the picture, leaving an observable area above 30% and below 70%, leading P&F practitioners, namely Tom Dorsey and Jeremy Du Plessis advocate adjusting sensitivity for the reduced area by increasing the % of the box size to 2%.  

❑  With P&F methodology for BPI Indexes, the only way a column can change into the opposite column is by reversing 3 boxes, this is the only way that the trend comes to an end and reverses into the opposing trend. 3 boxes by 2% per box = 6%.

❑  Specific to BPIs, a minimum net change of 6% in buy/sell signals is needed to cause a reversal, resulting in a change in columns from Xs to Os, or Os to Xs. 


So, where is the "Sweet Spot" for Sector Indexes?  When the corresponding BPI is between 36% and 64%.

❑  As the BPI of that Broad Market/Sector rises above 70%, the Index becomes OverBought. Strong Sell signals occur as the BPI rises above 70% reverses down by a minimum of 6%; signals become stronger with confirmed Breakdown patterns below prior Resistance levels.

– Downside Sweet Spots are between 64% down to 55% and  45% down to 36%.

❑  As the BPI of that Broad Market/Sector falls below 30%, the Index becomes OverSold.  Strong Buy signals as the BPI falls below 30% reverses up by a minimum of 6%; signals become stronger with confirmed Breakout patterns above prior Support levels.

– Upside Sweet Spots are between 36% up to 45% and 55% up to 64%.

❑  When the BPI of that Broad Market/Sector is range-bound near 50%, the BPI signals price indecision.

– Non-Directional Sweet Spot is between 45% to 55%.


❑  So, for example to trade options on the BKX (Financials sector Index), look at the $BPFINA (S&P Financial Sector BPI). Trade the BKX up/down/sideways, when the $BPFINA is within the Upside/Downside/Non–Directional Sweet Spots.
❑  It is within this range of the Sweet Spots, that P&F patterns (see below) retain their
ability to produce the intended outcomes, as price behaves in a non-erratic way for the signals to be taken as sensible.
❑  Why use this technique versus methods that show % changes mapping hot/cold areas in sectors/asset classes? "Heat" maps are merely graphic descriptions, failing to pin-point OverBought/OverSold conditions.
P&F Patterns
StockCharts uses commonly known P&F patterns as Alerts.  And Dorsey Wright also defines the patterns. Both explain and depict the required patterns adequately. I won't elaborate on them, as the purpose of this section is on their application beyond their definition.  There is no need to search for any other P&F patterns not listed in the Alert list, other than to recognise a ShakeOut pattern.

1 Buy Signal & 7 Buy Confirmation Patterns

❑  P&F Buy is only a signal, it is not a confirmed buy. The signal only shows that the last breakout was a column of Xs rising above the prior column of Xs and that no Sell Confirmation Pattern has occurred in the current O column.

Wait for these Buy Confirmation Patterns to occur:

❑  Double Top Breakout

❑  Triple Top Breakout

❑  Quadruple Top Breakout

❑  Ascending Triple Top Breakout

❑  Bullish Catapult Breakout (Triple Top Breakout + Double Top Breakout)

❑  Bullish Triangle Breakout#

❑  Spread Triple Top Breakout

#A Bullish Triangle Breakout is useful – pending were Volatility is at – for a Straddle/Strangle or Call/Put Backspread play, other than using it as a Vertical spread confirmation pattern for the upside.  Often the problem with triangles because price converges into an apex, it is not clear if the triangle is "Bullish" until price breaks out to the upside. Near the apex, price can reverse and break down instead.

Strength of breakouts build up as subsequent patterns are made up of prior breakouts.

With any of the Buy Confirmation Patterns, the ideal buy set-up would also include:

❑  Higher Bottoms (Higher O columns), meaning selling pressure is weakening.

❑  SMA 13 crosses-over SMA 21 to the upside. 13 and 21 are Fibonnacci numbers.

❑  Both Xs and Os move increasingly further above the Bullish Support Line, meaning buying pressure increasingly dominates selling pressure.  

1 Sell Signal & 7 Sell Confirmation Patterns

❑  P&F Sell is only a signal, it is not a confirmed sell. The signal only shows that the last breakout was a column of Os falling below the prior column of Os and that no Buy Confirmation Pattern has occurred in the current X Column.

Wait for these Sell Confirmation Patterns to occur:

❑  Double Bottom Breakdown

❑  Triple Bottom Breakdown

❑  Quadruple Bottom Breakdown

❑  Descending Triple Bottom Breakdown

❑  Bearish Catapult Breakdown (Triple Bottom Breakdown + Double Bottom Breakdown)

❑  Bearish Triangle Breakdown#

❑  Spread Triple Bottom Breakdown
#A Bearish Triangle Breakdown is useful – pending were Volatility is at – for a Straddle/Strangle or Call/Put Backspread play, other than using it as a Vertical spread play for the downside.  Often the problem with triangles because price converges into an apex, it is not clear if the triangle is "Bearish" until price breaks down. Near the apex, price can reverse and break out to the upside instead.

Strength of breakdowns build up as subsequent patterns are made up of prior breakdowns.  

With any of the Sell Confirmation Patterns, the ideal sell set-up would also include:

❑  Lower Highs (Lower X columns), meaning buying pressure is weakening.

❑  SMA 13 crosses-under SMA 21 to the downside. 13 and 21 are Fibonacci numbers.

❑  Both Xs and Os move increasingly further below the Bearish Resistance Line, meaning selling pressure increasingly dominates buying pressure.  


2 Trap Patterns

❑  Bull Trap. Reversal right after a Triple Top Breakout. Not relevant for other Buy Patterns.

❑  Bear Trap. Reversal right after a Triple Bottom Breakdown. Not relevant for other Sell Patterns.

Traps exist to ensnare you.  If you insist on trading them, then wait at minimum for 1 more box after the 1 box of a Triple Top Breakout/Triple Bottom Breakdown. As a Triple Top Breakout/Bottom Breakdown needs to happen before these Traps qualify, be on guard to watch for Traps right after the Triple Top Breakout and Triple Bottom Breakdown.

2  Shakeout Patterns – Cousins of Traps  (see Dorsey Wright)
As Traps are for Triple Top and Triple Bottom patterns, Shakeouts are for Double Top and Double Bottom patterns. You can avoid trading them. But if you insist on trading them, here's how ... 
Bullish Shakeout Pattern must have the following traits:
❑  Strong trend of Higher Xs and Higher Os, trading above the Bullish Support Line.
❑  Prior X columns form a Double Top but do not breakout (encounter resistance).
❑  Reversal from the Double Top resistance, the last O column becomes a Double Bottom Breakdown.
❑  From the Double Bottom Breakdown, in the current X column, buy at the 3rd reversal box and stay in play until a Triple Top Breakout completes the pattern.
Bearish Shakeout Pattern must have the following traits:
❑  Strong trend of Lower Xs and Lower Os, trading below the Bearish Resistance Line.
❑  Prior O columns form a Double Bottom but do not breakdown (encounter support).
❑  Reversal from the Double Bottom support, the last X column becomes a Double Top Breakout.
❑  From the Double Top Breakout, in the current O column, sell at the 3rd reversal box and stay in play until a Triple Bottom Breakdown completes the pattern.

What is more sensible as an entry technique, would be to  

❑  Recognize a Bull Trap, then switch from Buy mode to look for Sell Confirmation Patterns.

❑  Recognize a Bear Trap, then switch from Sell mode to look for Buy Confirmation Patterns.
2 Signals Reversed – Trend Stays a Friend, until it Ends

❑  Bullish Signal Reversed. A Double Bottom Breakdown reverses Higher Xs and Higher Os.  For entry, look for Bearish Confirmation Patterns. 

❑  Bearish Signal Reversed. A Double Top Breakout reverses Lower Xs and Lower Os. For entry, look for Bullish Confirmation Patterns.

As these reversals require 7 prior columns of Xs and Os at minimum before the current column to qualify as a signal reverse pattern, it makes sense to exit a trade completely – not just scale off part of the position, as the prevailing trend is over.  No chance of continuation.
2 More Reversal Patterns at 50% – Violently Undecided at the Mid-point

❑  High Pole Reversal. As the last column of Xs rises above the prior High by at least 3 boxes (some argue 5 boxes), but falls violently back to 50% at minimum of the height of its rise, volatility is likely to spike up past the mid towards higher deciles. 

❑  Low Pole Reversal. As the last column of Os fall below the prior Low by at least 3 boxes, (some argue 5 boxes), but rises violently back to 50% at minimum of the height of its fall, volatility is likely to spike down past the mid towards lower deciles. 
Poles present opportunities for Volatility option plays
❑ Namely, Straddles/Strangles as price has violently reversed up to 50% of the pole but is undecided where to go next.
❑ Or for Credit Spreads way OTM from price levels where poles have violently reversed from and are unlikely to return there, having travelled 50% in the opposite direction.
Deciding between which play makes sense, requires an understanding of Skewness & Probability.

1 Reversal Pattern to Avoid

❑  Low Tail Down Reversal. After a 20 box drop or more, while the first reversal may present Buy Confirmation Patterns, there must be other compelling reasons to take a long position on such a punishing fall in price. 

❑ As price has dropped so far down, volatility is likely to remain within the higher range with price struggling to rise, some would argue such opportunities may be considered as a  Short Iron Condor play. I would avoid opportunities that have suffered a harsh 20 box drop.
Conclusion: The What, When and Why of P&F with Relative Strength plus Sweet Spot trading has been expounded on.  Next, learn How  to use these identified P&F patterns in the entire Home Trading Process.