WHAT ARE PIVOT POINTS? – EXPLANATION WITH EXAMPLES
Introduction & Definition:
Pivot points are one of the most commonly used trading indicators in stock market trading. The tool provides a specific representation of seven support and resistance levels that are used to find intraday turning points in the market.
Below is a view of how they appear on a one-hour chart of the AUD/JPY currency pair. All seven levels are in view.
While traders often find their own support and resistance levels by finding previous turning points in the market, pivot points are automatically graphed on a daily basis. As many market participants track these levels, price tends to react to them.
THIS IS HOW THE CALCULATION OF PIVOT POINTS WORKS
Pivot points can be calculated for different time frames in some charting software programs (MetaTrader, for example) that allow you to customize the indicator. For example, some programs allow you to calculate pivot points for a weekly or monthly interval. However, the standard indicator is displayed at the daily level.
The central price level – the pivot point – is calculated as a function of the high, low and closing price of the market from the previous day (or, more generally, period). These values are summed and divided by three. This is the same concept as the “typical price”.
Pivot Point = [High (previous) + Low (previous) + Closing Price (previous)] / 3
The other six price levels – three support levels and three resistance levels – all use the value of the pivot point as part of their calculations.
The three support levels (more levels are possible depending on the setting) are conveniently referred to as Support 1, Support 2, and Support 3. The three resistance levels are referred to as Resistance 1, Resistance 2, and Resistance 3. You can also see them referred to by their short forms – S1, S2, S3 and R1, R2, R3.
These values are calculated as follows:
- Resistance 1 = (2 x Pivot Point) – Low (previous period)
- Support 1 = (2 x Pivot Point) – High (previous period)
- Resistance 2 = (Pivot Point – Support 1) + Resistance 1
- Support 2 = Pivot Point – (Resistance 1 – Support 1)
- Resistance 3 = (Pivot Point – Support 2) + Resistance 2
- Support 3 = Pivot Point – (Resistance 2 – Support 2)
Since price levels are based on the previous day’s high, low, and close, the larger the spread between these levels on the following trading day, the larger the spread. Similarly, the smaller the trading range, the smaller the distance between levels on the following day.
The use of pivot points
Pivot points were originally used in stocks and futures markets, although the indicator has been largely adapted to day trading in the foreign exchange market.
Pivot points have the advantage of being a leading indicator, meaning that traders can use the indicator to gauge potential turning points in the market in advance. They can either serve as trade entry targets themselves, using them as support or resistance, or as levels for stop losses and/or take profit levels.
For example, below we see several instances where S1 acts as support.
The pivot point, which is the center line and the level from which everything else is calculated. If price is trading above the pivot point, the market sentiment for the day could be considered bullish (although it is still possible for a market to trend down for the day if this is true).
When the market is sideways, the price can go down and flow around the pivot point. We can observe this type of price behavior in the chart below.
Although R1, R2 and R3 are referred to in the sense that they can probably act as resistance when the market is going up, if the price goes above them, they can also act as support when the price is going down. The same is true for S1, S2, and S3, which can act as resistance on any move up if they break as support.
For example, here we see a resistance level acting as support:
Using Pivot Points to Measure Probabilities
Pivot points are also used by some traders to estimate the probability that a price movement will support itself. Although it depends on the market, the following probabilities are generally given in terms of how likely it is that the price will close the trading day above or below the following levels:
- Closes higher than R1 40% of the time
- Closes lower than S1 40% of the time
- Closes higher than R2 15% of the time
- Closes lower than S2 15% of the time
- Closes in more than R3 5% of the time
- Closes below S3 5% of the time
Of course, these are only rough approximations. Just because the price moves above or below the outer levels does not necessarily mean that the movements are not valid or sustainable. For example, it should never be assumed that based on the above information you have an 85% chance of winning a trade if you take a long position when the price reaches S2. That alone will certainly not be true.
Pivot Points as Stop Losses
Some traders take trades at a level where they expect a reversal on contact, while using the next level below (in the case of a long trade) or above (in the case of a short trade) as a stop loss.
Here we see a short entry at R1 and a stop loss at R2.
TRADING WITH PIVOT POINTS EXPLAINED:
At this point, it should seem fairly straightforward that pivot points are used as likely turning points in the market. Taking trades at these levels in the direction of the expected reversal is a very common technical strategy.
To improve the feasibility of this strategy, traders will link the pivot points strategy with other indicators. For example, one could use a simple 50-period moving average to estimate the trend and bias their trades only in the direction of that trend.
Also, instead of the first touch of a pivot level, one might need a second touch to confirm that the level is valid as a turning point. Below is an example of why “confirming” the validity of a level is best done before making a trade on a base touch. This is a five-minute chart of the EUR/USD.
When data or news comes out, volume increases noticeably and the previous trade move and intraday support and resistance levels can quickly become obsolete. On the big red bar, price has actually held between the two pivot levels. But if we had traded every touch of the pivots, we would have made both a long and short trade within five minutes.
After that point, the market became firmly bearish and fell steadily, showing no sensitivity to the pivot points.
So you need to be careful and make sure that you are not trying to trade at levels that the market does not intend to respect when there is large volume in the market.
If we were to write down our rules for this system:
1. (a) When the 50-period simple moving average is positively sloped, take only long trades. (b) When the 50-period simple moving average is negatively sloped, take only short trades.
2. Take trades on a secondary touch of the pivot level after first confirming that the primary touch is a rejection of the level.
This is applied to a 5-minute chart, but can also be applied to higher (or lower) time compressions.
For day traders using daily pivot points, using the 5-minute to hourly chart makes the most sense. For swing traders using weekly pivot points, it is best to apply the strategy on the four-hour to daily chart. Position traders would probably be best suited to use monthly pivot points on either the daily or weekly chart.
Example of Pivot Trading
Here we have a 5-minute chart of the EUR/USD currency pair.
Price is in a downtrend for the day, price bounces off the S2 level once at the retracement (acts as resistance/support), resulting in a long trade on the touch.
This trade performed well after the downtrend ended shortly after. Furthermore, we can see on the picture that S1 acts as another support in the following trend (highlighted box).
Now, of course, the question is how to determine where to exit.
Before you place a trade, you must have an exit plan. This can take various forms.
- An exit at S1 would have been possible without any problems
- Stop loss could be tightened per candle
Shortly after the trade begins to move in our direction, some resistance forms. Of course, it may be reasonable to expect resistance to form there again in the future.
Moreover, when price begins to consolidate and any momentum in the trend – or market volume overall – has waned, we can simply choose to exit the trade at that point.
Or we can take a whiff of the moving average. Some traders use some of the more popular moving averages – 50, 100 and/or 200 periods – as support and resistance levels, or consider reversing the trend if price rises above the moving average being tracked.
Time – The trading hours are important for every trader
It should also be noted that pivot points are time zone dependent. Most pivot points are considered based on closing prices in New York or London.
Therefore, someone using charting software that uses a closing time based in San Francisco or Tokyo or another time zone may have other pivot points plotted on their chart that may not be tracked on a large scale internationally. This could potentially make them muted or worthless.
Accordingly, it is recommended that your chart times are set to either New York or London hours. How they relate to GMT or UTC depends specifically on where they are on the calendar, as both cities are on daylight saving time.
Regardless of the time zone you choose, know that pivot points can be tested retroactively by going through previous price data. It is important to make sure that the price is sensitive to these levels in the market you are trading.
Conclusion on Pivot Points
Pivot points provide a glimpse of possible future support and resistance levels in the market. These can be particularly helpful for traders as an early indicator of where price might turn or consolidate. They can also be used as stop loss or take profit levels.
While daily pivot points are the most common and best suited for day traders, some charting platforms allow you to plot them for other time periods (e.g. weekly, monthly).