Pivot Points are an investment strategy. It is a simple way for investors, to have some indication of which direction the market is moving during the course of any defined timescale, with some simple calculations.
The pivot point is the perceived level at which the market direction will change for the chosen trade period. Using some calculations using, the previous timescale high, low and close, a series of points are extracted. It is possible to use these points to plot support and resistance levels. Support and resistance levels calculated are known as pivot levels or potential Pivot Points.
Every timescale that you view a particular market, has an open, high, low and a close for any given trading period. This information basically contains all the data you need to use pivot points.
The reason pivot points are so popular is that they are predictive as opposed to lagging, most technical indicators are lagging because they rely on processing data, which takes time before it is presented. You use the information of the previous trading period to calculate potential turning points for the next trading period that you are about to invest in.
Many investors use pivot points to execute trades, therefore you will often find that the markets react to these levels (crowd theory). This gives you an opportunity to invest and get the correct entry/exit levels.
To work the pivot points out, one of the formula that can be used is.
Resistance 3 = High + 2*(Pivot – Low)
Resistance 2 = Pivot + (R1 – S1)
Resistance 1 = 2 * Pivot – Low
Pivot Point = ( High + Close + Low )/3
Support 1 = 2 * Pivot – High
Support 2 = Pivot – (R1 – S1)
Support 3 = Low – 2*(High – Pivot)
From the formula, by having the previous trading period high, low and close you end up with 7 chartable points, 3 resistance levels, 3 support levels and the pivot point.
The three most important pivot points are R1, S1 and the actual pivot point itself.
The most important thing to remember is that you don’t have to do the math, there are many free pivot point calculators on the market.
If the market opens above the calculated pivot point, then the emphasis for that time period is long trades. If the market opens below the pivot point then the emphasis for the time period is for short trades.
The theory behind trading pivot points is to look for either a reversal or continuation pattern, a break of R1 or S1. Usually by the time the market reaches R2,R3 or S2,S3 it could be overbought or oversold. Therefore, these levels could ideally be used for exit strategies rather than entries.
An ideal scenario would be for the market to open above/below the pivot level and then consolidate for a short time at R1/S1, then push on to reach R2/S2. You would enter/exit on a break of R1/S1 with a target of R2/S2 and if the market was particularly strong, close half your positions at R2/S2 (if you have multiple positions open) and target R3/S3 with the remaining positions.
Unfortunately the markets are not this simple and we have to deal with each time period with a best case scenario.
Example (GBP/USD) for a Daily timescale
High – 1.6747
Low – 1.6619
Close – 1.6640
Resistance 3 = 1.6847
Resistance 2 = 1. 6798
Resistance 1 = 1. 6719
Pivot Point = 1. 6669
Support 1 = 1.6590
Support 2 = 1.6540
Support 3 = 1.6462
The White line is the pivot point. The Red lines are resistance levels R1,R2 and R3. The Orange lines are support levels S1, S2 and S3.
Pivot Points are a great way to evaluate the market however, they should be used in conjunction with further analytical tools to confirm the investment.
The Breakout Trade
At the beginning of the time period Market Price was around the pivot point, so our focus is ambiguous (long or short). A channel formed before Point 1, so you would be looking for a break out of the channel. In this type of trade you would have your Buy entry order just above the upper channel line with a stop order just below the lower channel line and a target of R1. The market moved upwards and then retraced slightly. This is where discipline would have to take over and you would stick to your original Stop losses and Take Profits. The target is hit just before Point 2. An immediate retracement below the Pivot line ensued and then continued to a 2nd channel.
The Retracement Trade
The market hits R1 and then retraces to just below the Pivot line, it then forms a second channel. An entry short order is placed below support, which in this case was the most recent low before the retracement. A stop can be placed above the pullback (the most recent high – peak) the target price is set for S1, with the possibility of S2 (looking at the length of the candles and the angle).
Breakout of Support or Resistance
The market started retracing back from R1, it does not have enough momentum to continue up to R2. This is a riskier indication to execute a trade, a retracement. Entry orders can be positioned just below the R1 line, with a stop just above the R1 line, the first target price would be back to the pivot point.
There are many ways to trade using pivot points however it is a good idea to use a second indicator to confirm the signal. A more advanced method is to use the cross of two moving averages (MACD) as a confirmation of a breakout. Try not to use too many conformations or you may actually miss the trade. Remember they are the conformation of the signal and not the signal itself. It is also important to remember that the MACD is a lagging indicator therefore, you will lose a percentage of potential profits particular if it is a strong/fast market movement.
Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument. We do not and cannot offer investment advice.