. ;-temi contiuiiation cli.ntr Cocoa contract cli.iueed fr. ni cents/p. .uud to doU.nr/ton

Over the past 10 years, all markets have had one or more major price moves reaching levels often greater than twice their normal price. Sugar and silver eadi topped at 10 times their starting value. These moves necessitate changes in box size to control the impact of the increased, and later decreased, volatility.

Alternating with extremely high prices are periods in which many commodities fall to levels near their production costs. Table 11-1 shows part of the history of changing box sizes based on a 3-box reversal, for agricultural markets during the late 1960s compared with the mid-1980s. By noting the historic price moves, the change in volatility can be related to the change in box size. Whereas most agricultural markets show a pattem of small to large to small box sizes, coffee and orange juice have remained volatile. Silver and gold maintain large box sizes through the mid-1980s, as a result of their long steadj

TABLE 11-1 b Point-and-Figure Box Sizes

declines; however, current levels would require a reduction. Rules for varjing box sizes and risks associated with these changes will be discussed in the next sections.

The Nature of Mart:ets

Financial markets have underljing differences from agricultural ones, interest rates have the greatest similarity, with the exception that a low volatility level for rates is associated with high prices. To create a point-and-figure chart for Eurodollars with the same orientation as soybeans, it is necessarj to plot the yield, rather than the price, of the marfcet. This is easj for any 3-month rate, because the current price can be subtracted from 100; for longer maturity bonds this is more difficult, but could be estimated by subtracting the current price from 164, or by dividing 800 by the futures price.

Currencies present another unique problem, because ihere is no low or high price for foreign exchange, only what the market decides. When an economy strengthens, the value of the currency increases; when the economy falters. Its currency devalues. Sometimes, as happened in the U.S. from 1985 to 1995, the govemment may choose to allow the currency to decline as a way to reduce its debt. Does this mean that the U.S. dollar is low and that its volatility wdl decline? No. With agricultural products, when prices fall to production levels there is less trading and lower volatility, the result of lack of interest. The dollar, however, can continue to decline and its volatility can increase as long as fraders believe that the current situation is changing. Therefore, the volatility of a currency is low when market participants see its price as correct, at equilibrium, if prices move away from equilibrium, and the govemment disapproves of what is happening, economic policy will attempt to move it back., therefore, currency prices can be volatile when they move in either direction away from equilibrium. This makes it difficult to scale prices by a percentage, as we will do in later sections.

THE PROBLEM OF RISK

I go long or short as close as I can to the danger point, and if the danger becomes real 1 close out and take a small loss.

Jesse Livermore to Richard Wyckoff

Wyck..ffS..cklJaiketTecUuique,Nun,ber:ueWyck..ffNewY.d . 1933,p J.

if the point-and-figure method is accepted as successful, why is it necessarj to modifj the basic signal and use trendlines and geomehic formations to 1 1 1 new signals? TTie answer involves the risk of an individual frade. The

difference in treatment of tlie same price move can be seen by loolcing at botli a bar cliart and a corresponding point-and-figure cliart for the same period (Figure 11-6). The most basic bar chart trading method uses horizontal support and resistance trendlines to define a rectangular trading range., when the resistance line is penetrated, a long position is taken. A stop-loss is placed below the resistance line to close out the position in the event of a false breakout. An alternate place for tiie stop-loss could have been below the support line allowing the new bull move some latitude to develop. The interpreted bar chart makes the selection of the entrj point and the placement of stops seem obvious, however, when trading, the placement of the support and resistance lines is not as clear. The time to enter a trade after a breakout is never certain, and the position for the stop depends on the volatility of prices and the risk that can be assumed.

in contrast to the ambiguity of the bar chart, the pointand-figure metiiod defines the support and resistance levels exactly, establishes a place to buy in advance, and designates the position for the stop-loss below the rectangular congestion area. The rigidity of the metiiod allows only one place for the stop-loss and fixes the rid; as the difference between the support and resistance lines, a total of 5 boxes in this example, in the bar chart, the rid; might have been held to the equivalent of 2 boxes using the first sU-ategy; however, a very small risk often results in being stopped out of the trend prematurely.

TRADING TECHNIQUES

There are alternate metiiods for selecting point-and-figure entry and exit points that have become popular. Bujmg or selling on a pullback after an initial point-and-figure signal is one of the more common modifications to the sjstem, because it can limit risk to any level and still maintain a logical stop-loss point. Of course, the smaller the rid;, the fewer the opportunities and the more likely you will be stopped out. There are two approaches that are recommended for entering on limited rid;:

1. Waitfor a reversal back to within an 1 1 risk, then buy or sell immediately with ihe normal point-and-figure stop. Figure 11-7 shows various levels of risk using com (a 5,000-bushel contract, with $ 50 for each 10 moveV The initial buy signal is at 258, with the simple sell sienal for liquidation at 249, giving a risk of 90, or

FIGURE 11 -6 Placement of stops.

FIGURE 11 -7 Entering on a pullback.

$450 per contract. Wait for a reversal following the breakout, and buy when the low for the day penetrates the box corresponding to the predetermined rid;. Buying into a declining maiket assumes that the support level will hold, preventing the stop-loss point from being reached. Because of this, the base of the formation should be as broad as possible. The test of a friple bottom or a spread friple bottom after a buy signal is a more reasonable place to go long than a simple buy after a small reversal in the middle of a move.

It is not advisable to reduce rid; by entering on the simple buy signal and placing a stop-loss at the point of the

first reversal (3 boxes below the highsj. The advantage of waiting for the pullback is that it uses the logical support level as a stop. A stop-loss placed nearby following a breakout has no logical basis and will quickly result in a losing trade

2. Enter the market on the second reversal bad; in the direction of the original signal. As shown in Figure 11-8, the first reversal following a signal may not be within the desirable ride but by placing a trailing entry order using the point-and-figure reversal value, while prices are moving counter to the direction of the signal, an entry will occur on a confirmation of the original direction with a stop-loss at the minimum 4-box distance.

FIGUREl 1 -8 Entering on a confinnation of anew trend after a pullbad;

This technique is frequently used by traders who firmly believe that a reversal follows immediately after a breakout and prevents both high risk and false signals. If the pullback that follows the breakout continues in an adverse direction, penehates the other support or resistance level, and friggers the original sjstem stoploss, no entry occurs, thus saving a substantial whipsaw loss.

The reversal principle in step 2 can also be effective for building positions. In bar charting, a pullback to a bullish support line or a bearish resistance line was a point for adding to a position with a rid; limited to pendration of the major trendline. The equivalent procedure using point-and-figure is to add on eadi reversal back in the direction of the trend using the newly formed stop-loss point to exit the entire position as shown in Figure 11-9

3. Allowing for irregular pattems. Price pattems are not alwajs as orderly as we want them to be, and the price activity at time of a frend change can be very indecisive. One basic trading principle demands that the market confinns a new high before bujing; the first new high might simply be an erratic sideways pattem, or an expanding formation after a period of low volatility. If we require prices to make a new high by more than 1 box on the next upward thrust, and increase the minimum by another box on the third upward thrust, we can actually demand that the momentum increase before a position is set.

This technique, which tends to minimize false breakouts, may be modified to increase the confinnation threshold from 2 to 3 or 4 boxes as market volatility increases. If the box size is changed according to volatility, as discussed later in this chapter, confirmation can remain at 2 boxes.

Take It and Run!

There comes a time in most substantial moves when there is ample profit and apprehension about how much of the paper profit will be returned before the sjstem close-out signal is readied. Some traders prefer to take the profits. These are decisions that go beyond the area of technical analysis. If the profit currently held in open positions is enough to sustain a life of leisure, a home in the mountains or Soutti Seas, a countrj club, and a small investment in a hotel or restaurant to occupy your time, then take it and run! A trading sjs

Alan. HewiEon, "The WiH I ..gers The..

.fP.4ut&FieureTra<iue." TecWical Analysis ..f . .- & Cjiiniodities (August 1991)

FIGURE 11 -9 Three wajs to compound positions.