Trading strategy
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.