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

Trading stocks with pivot points

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.

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