From the March 01, 2012 issue of Futures Magazine • Subscribe!

A key market metric for professional stock traders is the level at which price reacts and moves swiftly to either the upside or downside. Sometimes referred to as support and resistance, these levels aren’t constructed by magic. Often, they are based off a previous sequence of significant price highs or lows.

However, another tried-and-true method for identifying these key areas of acceleration and capitulation is the pivot point and its associated support and resistance levels. All technical day and swing traders in the stock market should understand how to calculate, interpret and trade with pivot points.

The pivot point is simply a level at which the market chooses direction. Of course, we prefer to know these points beforehand; therefore, methods have been developed that calculate a day’s likely pivot points based on prior price action.

There are variations to pivot point calculations. The most popular uses the average of the previous day’s high, low and close to derive a series of price points. The support and resistance levels that are calculated from these points indicate potential trading ranges for the next trading session. These are known as pivot levels.

The most straightforward of these five levels is the pivot average itself. It is known as P, and is simply the sum of the previous day’s high, low and close divided by three. On the support side, there are S1 and S2. On the resistance side, there are R1 and R2. In the following equations, H is the previous day’s high and L is the previous day’s low:

S1 = (P x 2) – H
S2 = P – (H – L)
R1 = (P x 2) – L
R2 = P + (H – L)

As you can see from the equations, the first resistance and support levels are calculated using the difference between the pivot point and the previous day’s high or low. The second resistance and support levels are based on the entire width of the previous day’s trading range.

In addition, many traders also reference a third order extension of the support and resistance levels. These formulas are:

S3 = L – 2 x (H – P)
R3 = H + 2 x (P – L)

It is rare for a stock or index to hit its daily R3 or S3 levels. If a market rallies to R2 or sells off to S2, this often ends up being high or low of the day. This is usually the safe choice, and keeping this tendency in mind will help temper your emotions when markets start to move quickly.

The most important level is the pivot level itself. It is the level above or below which price is expected to advance toward R1 or S1.

Although pivot points and levels most often are calculated for a day’s session, they also are used on an hourly basis. In another application, many traders apply the daily pivots on hourly, 30-minute, 15-minute and five-minute charts. The theory behind this use is that the daily pivots are more reliable than pivots derived from shorter time frames, which are less accurate and significant.

With the assumption that the pivot is the trend-deciding level for a particular day, we can formulate some basic rules for trading with pivots:

• If the stock trades above the pivot point, then the bias for the day is long. Look to buy.
• If the stock trades below the pivot point, then the bias for the day is short. Look to sell.
• If the market opens, gaps up or gaps down and trades near R2/R3 or S2/S3, it will exhibit a tendency to trade back toward the pivot. Understanding this will help you avoid buying the high or selling the low.
• If either S1 or R1 is penetrated, these breakout points will reverse their roles. That is, the first support, S1, becomes the new resistance, R1.

While this, or any one-dimensional strategy, is not recommended as a standalone trading approach, we can present it here as such to demonstrate the application of the logic. To that end, let’s walk through some trading examples, first with the S&P 500 stock index and then with individual stocks. For the index, we’ll use Dec. 8, 2011, as our sample date. To start our analysis, we back up one day to Dec. 7 when the S&P 500 registered the following: High of 1267.06; low of 1248.0; close of 1261.01. Using the pivot formulas, this gives the following pivot levels:

P =1258.7
R1 =1269.4 S1 = 1250.3
R2 = 1277.8 S2 = 1239.6
R3 = 1288.4 S3 = 1231.3

“Target levels” (below) shows a five-minute chart of the S&P 500 on Dec. 8 and demonstrates how we could have traded using these levels. The market opened at 1260.87 and immediately traded lower. As per our pivot strategy, we take a short trade below pivot at 1257.60, placing a stop at two points, or 1259.60.

The first target for the trade is S1, or 1248.20. At this level, we either could book profit or trail the position by dropping our stop. The second target for the trade is S2, or 1235.40. At this level, a trader should book full profit. In this case, the pivot strategy worked quite well. The low made by the S&P 500 on Dec. 8 was 1234.35.

The strategy works the same on individual stocks. On Dec. 8, Caterpillar had the following data: High of 95.53; low of 92.60; close of 92.92. This produces the following pivot levels:

P = 93.7
R1 = 94.8 S1 = 91.8
R2 = 96.6 S2 = 90.8
R3 = 97.7 S3 = 88.9

We can see Caterpillar’s price action on Dec. 9 in “Swing higher” (below). It opened at \$93.63 and traded in a narrow range. Following our pivot strategy, we go long above the pivot of \$93.80, using the initial day’s low of \$93.44 as our stop loss.

The first target for the trade is R1, or \$94.80. At this level, we either could book profit or move our stop loss higher to, say, the entry price. The second target for the trade is R2, or \$96.60. Caterpillar’s high on the day was \$96.29, or 31¢ short. Because this is a day-trading strategy, we square our account at the market’s close.

Not only can pivot points be used to find profitable breakout trades, but they can be used to trigger successful long and short trades in the same day.

Often, the best trading tools are the simplest, and pivot points qualify. They are handy tools for day traders to predict potential market turning points. That said, as with most indicators, pivots never should be used in isolation, but with a combination of complementary tools, such as candlestick charts, MACD and stochastics.

AutoZone provides a good example of using pivot levels to trade both the long and short sides in one day. On Dec. 29, 2011, AutoZone recorded: high, \$329.31; low, \$325.40; close, \$326.25. This offers the following pivot levels:

P = 327.1
R1 = 328.6 S1 = 324.7
R2 = 330.9 S2 = 323.1
R3 = 332.5 S3 = 320.8

“Zoned for profits” (below) shows a five-minute chart of AutoZone on Dec. 30. The stock gapped down at \$324.88 on the open. However, as the market trades higher, we look to go long above our \$327.10 pivot. With the interim low relatively far from the current price, we opt to use a one-point stop loss at \$326.10.

The first target for the trade is R1, or \$328.60. At this level, the decision is the same: book profits or move the stop loss higher. The second target for the trade is R2, or \$330.90. However, AutoZone was unable to stretch that far, and dropped lower, triggering the stop loss.

As the stock moved below the pivot level, we can opt to place a short trade at \$327.50 with a stop loss at \$328.60 and a profit target of S1, or \$324.70. AutoZone eventually reached \$324.70 in last hour of trade, allowing us to book our profit.

Bramesh Bhandari trades the Indian stock market and teaches technical analysis to traders. He can be reached at bhandaribrahmesh@gmail.com.

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