Many currency traders have probably heard the term “pivot points” and know it has something to do with average price ranges and support and resistance levels. Knowing the term is one thing, applying it effectively is another. Trading with pivot points is certainly an art form, but traders who are minus the understanding of certain core concepts outlined in this article, are better off leaving their paint and art supplies behind.
Key to understanding pivot point levels is the idea of support and resistance. Support and resistance levels give traders a visual gauge of pressure points within the market, specifically at certain price levels.
The following excerpt, from a technical analysis course at Interbank FX (www.ibfxu.com), explains support and resistance levels as applied in the stock market; the same principles are also applicable to the currency market.
A support level is a price level at which sufficient demand for a stock appears to hold a downtrend temporarily at least, and possibly reverse it. i.e., start prices moving up again. A resistance zone by the same token, is a price level at which sufficient supply of stock is forthcoming to stop, and possibly turn back, its uptrend. There is, theoretically, a certain amount of supply and a certain amount of demand at any given price level... But a support range represents a concentration of demand, and a resistance range represents a concentration of supply. (The above was taken from TA 1030, a guest course in Interbank FX’s University. Content for this course was taken from chapter 7 of Clif Droke's book Technical Analysis Simplified.)
To summarize the above, support levels are considered levels at which price decline is continually rejected. Conversely, resistance levels are considered levels at which price increase is continually rejected. Traders looking at a support level and resistance level in conjunction with one another are essentially examining what is referred to as a channel. It is very common to see price trends within the bounds of trading channels; meaning that for hours, or perhaps days at a time, a currency may trade within the bounds of support and resistance levels. Many times throughout a trend, the price may test either the support or the resistance level, but ultimately if the price is to remain within the channel the support and resistance levels will be tested, but not pushed through.
Just the opposite of what is explained above, if a support or resistance level is tested for hours or days on end without a breakout, and finally the price does push through the bounds of this channel, it may be considered a strong indication that the price will take on an entirely new direction / trend.
When to Use Pivot PointsUsually, Foreign Exchange traders watching support and resistance levels are looking for one of the following trading opportunities:
A chance to sell after a resistance level has been pushed, but not broken through several times. The trader’s entry would likely be at the end of a strong bearish candle that began with a touch of the resistance level.
A chance to buy after the support level has been pushed, but not broken through several times. The trader’s entry would likely be at the end of a strong bullish candle that began with a touch of the support level.
A chance to buy after a previously tested resistance level is finally pushed through with a strong bullish candle. In other words, buyers in the market have tried numerous times to push prices above a resistance level, yet have failed. Finally prices breakthrough in the form of a strong up-candle, indicating that perhaps, buyers will finally have their way and push the price higher.
A chance to sell after a previously tested support level is finally pushed through with a strong bearish candle. In other words, sellers in the market have tried numerous times to push prices below the support level, yet have failed. Finally prices breakthrough in the form of a strong down-candle, indicating that perhaps, sellers will finally have their way and push the price lower.
The Pivot Point DifferenceAs is explained above, there are multiple scenarios in which a trader might utilize support and resistance levels as a means to identify key entry and exit points. Pivot points are very similar to support and resistance levels. In fact, pivot points are simply a series of support and resistance levels, with the inclusion of a median price level.
Standard pivot points include five levels (levels that are represented as distinct lines on your charts). The median level, or middle line of the five, is called the ‘pivot point’. The other four levels are found above and below the pivot point in the form of two support lines (S1 and S2) and two resistance lines (R1 and R2).
Using the previous trading session’s open, high, low and close in order to calculate these pivot levels gives traders an added advantage beyond simply looking at one support level and one resistance level. Using pivot points, traders are able to gauge support and resistance levels on a scale in relation to an average price range (the pivot point or line itself) for the trading session.
As is the case with many forms of technical analysis, the actual math of pivot points in terms of its ability to predict price movement is certainly questionable. But, experienced traders understand that the science of the math is completely irrelevant. Rather, what does matter is that so many traders are utilizing pivot points as a means to gauge support and resistance levels.
Always, bear in mind the crucial importance of market sentiment. For example, if millions of technical traders are all watching the same support and resistance levels and buying and selling in accordance with those levels; market sentiment can quickly become market reality. Pivot points may be as effective as they are at times simply because so many traders are basing trades on the same levels. Or, perhaps, there is magic found in these simple calculations.
Calculating Pivot PointsIn comparison to the endless barrage of technical indicators available today, pivot point calculations are actually quite simple. Key figures are derived from the open, high, low and closing price of the previous day’s trading session. Most professional traders, recommend that these figures be based on trading days or sessions started and ended at 0:00 Greenwich Mean Time (GMT). GMT is used to mark the start and end of trading days because it is considered a globally central time.
The actual calculations for pivot points are outlined below, though please do not fret; these calculations are shown for your reference, but will not need to be mastered in order to utilize pivot points, as most brokers provide sometime of chart plug-in that will calculate levels for you:
Pivot Point (PP): High + Low + Close / 3
The subsequent calculations for support and resistance levels are based on the number calculated for the pivot point itself and are as follows:
First Support (S1): (2 x PP) - High
Second Support (S2): PP - (High - Low)
First Resistance (R1): (2 x PP) - Low
Second Resistance (R2): PP + (High - Low)
Use DiscretionAs is the case with many technical analysis indicators, pivot points are far from an exact science. Though various trading methods were outlined above, these methods are simply an outline of how a technical trader might use support and resistance or pivot points in their trading process. A seasoned trader would take into account other factors that will most certainly affect the market, a factor such as major fundamental indicators (news announcements). Pivot points may be completely irrelevant technically when trading right after a major fundamental news announcement.
Tips To ConsiderTypically, pivot points tend to work well if traders understand a few of the following tips:
Prices tend to volley between two pivot lines, in other words if a price is right at S1 it is most likely to move back toward PP, only a fairly strong bearish candle would indicate a further break and move towards S2. Just the same, if a price is at R1 it is most like to move back towards PP and only a strong bullish candle would indicate a move towards R2. When prices are trading at the pivot line itself, look for a strong series of bullish or bearish candles to indicate a move back towards R1 or S1.
Pivot points seem to work the best in moderately sideways markets, or on a currency pair that is not experiencing significantly strong bullish or bearish trend over the previous few days.
SummaryOf course, pivot point analysis is never perfect, no form of analysis is. Pivot levels tend to work the best when used in conjunction with other technical analysis techniques; try considering your pivot levels alongside your MACD or Stochastic (overbought and oversold levels), the overall trend of the market, chart patterns and perhaps one other tool of your liking. If three of four signs are positive, and you are not trading during Nonfarm Payroll – consider your analysis strong. The market is yours for the taking, but be sure to prepare your analysis before diving in headfirst; or you will be the one being taken!
An experienced trader and industry professional, Nathan is the chief writer and developer of Interbank FX’s free online university, IBFXU. Nathan has conducted numerous seminars for both beginning and advanced traders across the US and abroad.
