Forex Trading System- The Point and Figure Algorithm

OVERVIEW

Point and figure (P&F) charts are members of a genre of charts normally referred to asreversal charts. A reversal chart is any chart that filters the raw data in order to accentu-ate significant points of interest while ignoring points of less interest. All technical ana-lysts find peaks and valleys of great interest while areas of lateral price movements areless interesting. Peaks and valleys are those points of inflection where price directionsreverse and the slope of an existing trend changes its arithmetic sign (minus to plus andplus to minus).

P&F ANATOMY

Price advances are represented as vertical columns of Xs while price declines are repre-sented as columns of Os. (See Figure 12.1.)

Two user-supplied variables are required to plot a point and figure chart, box size,and reversal amount.

BOX SIZE

Traditionally, the minimum price unit is the smallest fractional price increment bywhich the quote currency (or underlying security) can change. In the currency markets,this increment is a single pip. For example, if the EURUSD currency pair is currentlytrading at 1.2451, a single pip is 0.0001 USD.

There are cases where a box size greater than one pip might be used such as whenthe parity rate between two currencies is very wide and causes a very large bid/askspread. For example, if the bid/ask spread (transaction cost) for the EURCZK currencypair is 350 koruny, then a one-pip box size will have very negligible filtering power.

A second reason for using a box size greater than one pip occurs when performinghistorical analysis and a longer time frame is being analyzed. In this case, the analystwill probably be scrutinizing major reversals and may have little interest in minor rever-sals. This pertains more to position traders than session or day traders.

REVERSAL AMOUNT

The reversal amount is the number of boxes necessary to plot a reversal in price direc-tion. For instance, if the current trend is upward and the reversal amount is set at threeboxes, then a decline of three box units must be reached before the downward move-ment is plotted. If instead, a new price continues in the direction of the existing trend,then single boxes are automatically added to the last extreme (either a peak or a valley).

It is the mutual interaction between the box size and the reversal amount that trig-gers the reversal mechanism in the reversal algorithm necessary to plot new columns ofXs and Os while ignoring lateral price movements.

There is one final case for increasing the box size. If an analyst, for whatever rea-son, has become very partial to one specific reversal amount, it is possible to increasethe box size instead of the reversal amount when market conditions change.

For example, a three-box reversal amount is favored by many traders. If traderswish to filter out some of the minor reversals, they can increase either the reversal

POINT AND FIGURE CHARTING

However, keep in mind that although a two-pip box size with athree-box reversal amount algorithm will generate results very similar to a one-pip boxsize with a six-box reversal amount algorithm, they will not be identical. This requiressome reflection. The reason is that, when plotting a continuation of an existing trend,smaller distances can be plotted when a smaller box size is used.

UNRAVELING BAR QUOTE DATA

Before we explain the intricacies of the P&F reversal algorithm, we need to massage theOHLC quote data into a stream of single values (closes only). The four bar quotes (open,high, low, and close) must be stretched out and ordered according to which occurredfirst. Actually, this applies only to the high and low quotes, and the Visual Basic 6.0 “un-raveling” routine is given in Appendix N. This greatly simplifies the reversal algorithm inthe next section.

P&F ALGORITHM

Upward trends are represented as a vertical column of Xs, while downward trends aredisplayed as an adjacent column of Os.

New figures (Xs or Os) cannot be added to the current column unless the increase(or decrease) in price satisfies the minimum box size requirement. A reversal cannot beplotted in the subsequent column until the price has changed by the reversal amounttimes the box size.
Programmatically, this first step to plotting a point and figure chart is to determinethe number of Xs and Os in each alternating column and to store the values in a globalarray. A separate function was written to accomplish this goal.

Given the information and user-supplied variables, we will now define the swing re-versal algorithm as follows (this algorithm assumes we are using daily OHLC quotes asthe input data):
Step 1: Initialize BoxSize and ReversalAmount variables.Step 2: Create a new variable called Direction.Step 3: Create an array variable called Price(MAX_PRICES).Step 4: Set Price(1) = Close(1).Step 5: If Close(2) – Price(1) > BoxSize * ReversalAmount Then
Set Price(2) = Close(2)
Set Direction = UP
ElseIf Price(1) – Close(2) > BoxSize * ReversalAmount Then
Set Price(2) = Close(2)
Set Direction = DOWN
The Point and Figure Algorithm
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Else
Increment day number and repeat Step 5End If
Step 6: Increment DayNo
If DayNo = Number of Closes Then
Go to Step 9
If Direction = DOWN Then
Go to Step 8
End IfStep 7:If Close(DayNo) – Price(Idx) > BoxSize Then
Set Price(Idx) = Close(DayNo)
ElseIf Price(Idx) – Close (DayNo) > BoxSize * ReversalAmount Then
Increment Swing Idx
Set Price(Idx) = Close (DayNo)
Set Direction = DOWN
End If
Go to Step 6Step 8:If Close (DayNo) – Price(Idx) > BoxSize * ReversalAmount Then
Increment Swing Idx
Set Price(Idx) = Close (DayNo)
Set Direction = UP
ElseIf Price(Idx) – Close (DayNo) > BoxSize Then
Set Price(Idx) = Close (DayNo)
End If
Go to Step 6Step 9:Set Number of Swings = Swing Idx
Exit

At this point the array Price() has been populated with the necessary P&F data. Thecomplete code for the preceding algorithm written in Microsoft Visual Basic 6.0 isprovided in Appendix N.

TIME REPRESENTATION

Adherents of the point and figure charting method believe that the compression of timealong the x-axis is an advantage since the trader can then focus solely on price move-ments. Proponents of swing charts, by contrast, are more comfortable viewing thepoints of inflection (peaks and valleys) as they occur in real time.