Before computers and ADP equipment, pivot points were used by floor traders on equity and futures exchanges as a simple way to forecast the direction of the market during the day. Despite often being included in historic trading strategies, pivot points are still used by Forex traders to determine support and resistance levels. Pivot points actually work very well in Forex markets because of the large size of the market, especially when used with very liquid pairs.
Pivot points basically provide a trader with reference points. These points help to determine when to enter the market, place stops and exit. Each point basically supplies a support or resistance level. The pivot point and levels are calculated based on information from the previous day.
There are several different ways to calculate pivot point and levels. In fact, there are eight different formulas for just calculating the pivot point. Different methods include the Woodie, Camarilla and Tom DeMark pivot points. The simplest formula uses the High, Low and Close from the previous day. There are three levels of resistance, the pivot point and three levels of support.
Calculations are made as follows:
To determine the actual pivot point:
Pivot Point = (High + Low + Close) divided by 3
The first resistance and support levels are now calculated:
Resistance 1 = (pivot point times 2) – Low
Support 1 = (pivot point times 2) – High
The second resistance and support levels are calculated:
Resistance 2 = (R1 – S1) + pivot
Support 2 = (R1 – S1) – pivot
The third resistance and support levels are calculated:
Resistance 3 = [2 times (pivot-low)] + high
Support 3 = [2 times (high - pivot)] + low
There are a select few analysts who actually go as far as adding a fourth level of support and resistance, however this often becomes a bit esoteric for trading purposes. There are also ways of tracking the mid-points between each level.
The pivot point on a day with an high of 1.2297, a low of 1.2213 and a close of 1.2249 would calculate to be 1.2253. Using the pivot point, we then set our support and resistance levels. They will go from top to bottom on the chart as follows:
R3 = 1.2477
R2 = 1.2337
R1 = 1.2293
Pivot point: 1.2253
S1 = 1.2209
S2 = 1.2169
S3 = 1.2125
The best way to fully understand how pivot points work is to actually do the math yourself, looking at the forex charts. Using the EUR/USD, calculate your pivot points, support levels and resistance levels. You will notice that the trading range for the session you are looking at will usually occur between R1 and S1, with the pivot point being at the center of the movement. The majority of breaks will occur around one of the market opens. At this time there is an influx of traders entering the market.
There are many different strategies to use pivot points, including the combination of identifying candlesticks with pivot levels. For example, if prices are trading below the pivot point, but then break above the pivot while forming a doji, the trader might sell short because of the expected drop back below the pivot point.
The pivot point can also be used to validate the strength of a movement. For example, the price breaks the pivot level, reverses and then trends back towards the pivot level. It then moves through the pivot point. This could indicate that the pivot level is not very strong. However, if a price hesitates around the level for a period of time, the pivot may be more significant. A future move towards the pivot point may actually be a break, indicating future movement.
Pivot points are also used to judge the probability of a move. For example, analysis shows that between the inception of the Euro on October 12, 2006, the actual low has been lower than the average S1 44% of the time. A trader my put a stop below S1 with confidence, based on probability. However, this information is generally more useful as a support tool to limit risk, combined with other types of analysis.
In general, there are a few tips to keep in mind when it comes to using pivot points:
When a price opens at a certain level, it will generally move to the next level on either side. For example, if it opens at pivot point, it will move back to R1 or S1. If it opens at S2, it will move to S3 or S1.
When there is no significant news or events to influence the market, the price will usually be confined between R1 and S1.
Significant news can drive the price to R3 or S3.
R3 and S3 are usually the maximum ranges for extremely volatile movement during the day. But they are just an estimation, not a certainty.
In a strong trend, the price will go straight past a level without any hesitancy at that point.
Many different types of traders use pivot points as a key part of technical analysis. Technical indicators, such as pivot points, help traders to identify levels of support and resistance. They help to identify moves that can be considered as breakouts and where the maximum and minimum ranges of movement will occur. Understanding the turning points provide an investor with the ability to make educated transaction decisions. Pivot points can be used with many trading strategies, making them a simple and useful tool for trading.