Initial draft of article 10. This will be expanded and refined.

The Law of Cause and Effect: Point and Figure Charts

Excerpt: The Law of Cause and Effect is a central pillar of the Wyckoff methodology, providing a framework for estimating the potential extent of a price move. By using Point and Figure (P&F) charts to quantify the "cause" built during a trading range, traders can project a logical "effect" in the form of a price target.

Tags: wyckoff-method, cause-effect, point-and-figure, p&f-charts, price-targets-exp19

In a world of seemingly random market fluctuations, the Wyckoff method offers a structured approach based on logical principles. One of the most effective of these is the Law of Cause and Effect. This law posits that the duration and intensity of an accumulation or distribution phase (the "cause") will determine the magnitude of the subsequent markup or markdown phase (the "effect"). The longer the cause, the greater the effect.

To measure the cause, Wyckoff turned to a unique and effective charting technique: the Point and Figure (P&F) chart. Unlike traditional bar charts that plot price against time, P&F charts filter out the noise of insignificant price movements, focusing solely on price reversals of a predetermined magnitude. This allows the Wyckoffian analyst to clearly see the horizontal extent of a trading range, which is the visual representation of the cause.

Using Point and Figure Charts to Determine Price Targets

The process of using P&F charts for price projections is straightforward and logical. The horizontal width of a trading range on a P&F chart is measured in columns. This "count" is then used to project a potential price target.

The Horizontal Count as a Measure of the 'Cause'

During an accumulation phase, the Composite Operator (CO) is absorbing shares. The longer this process takes, the more shares the CO is able to acquire, and the greater the potential for the subsequent price advance. The horizontal count on the P&F chart is a direct measure of the time and effort the CO has expended in building this cause.

Formula for Calculating P&F Price Objectives

The formula for calculating a P&F price objective is as follows:

For an uptrend (from an accumulation base): Price Objective = (P&F Count * Box Size * Reversal Factor) + Low of the Counting Area

For a downtrend (from a distribution top): Price Objective = High of the Counting Area - (P&F Count * Box Size * Reversal Factor)

Where:

• P&F Count: The number of horizontal columns in the trading range.
• Box Size: The price increment for each "X" or "O" on the chart.
• Reversal Factor: The number of boxes the price must reverse to create a new column.

Case Study with P&F Chart and Count Analysis

Let's consider a hypothetical stock, XYZ, that has been trading in a range between $40 and $50 for several months. We will use a P&F chart with a $1 box size and a 3-box reversal.

The P&F chart of this action would show a horizontal count of, let's say, 15 columns in the $40-$48 range. We can now project a price target:

Price Objective = (15 * $1 * 3) + $40 = $85

This projection gives the Wyckoffian trader a logical target for the upcoming markup phase. It is not a guarantee, but it provides a roadmap for managing the trade and taking profits. The same methodology can be applied in reverse to project downside targets from a distribution range.

By integrating P&F analysis into their workflow, traders can move beyond simple trend following and begin to anticipate the magnitude of market moves, adding a effective dimension to their trading strategy.