Pivot Points
Professional traders and market makers use pivot points to identify important support and resistance levels. Simply put, a pivot point and its support/resistance levels are areas at which the direction of price movement can possibly change.
Pivot points are especially useful to short-term traders who are looking to take advantage of small price movements.
Pivot points can be used by both range-bound traders and breakout traders. Range-bound traders use pivot points to identify reversal points. Breakout traders use pivot points to recognize key levels that need to be broken for a move to be classified as a real deal breakout.
Here is an example of pivot points plotted on a 1-hour EUR/USD chart:
How to Calculate Pivot Points
The pivot point and associated support and resistance levels are calculated by using the last trading session’s open, high, low, and close. Since Forex is a 24-hour market, most traders use the New York closing time of 4:00pm EST as the previous day’s close.
The calculation for a pivot point is shown below:
Pivot point (PP) = (High + Low + Close) / 3
Support and resistance levels are then calculated off the pivot point like so:
First level support and resistance:
First support (S1) = (2*PP) – High
First resistance (R1) = (2*PP) – Low
Second level of support and resistance:
Second support (S2) = PP – (High – Low)
Second resistance (R2) = PP + (High - Low)
Don’t worry you don’t have to perform these calculations yourself. Your charting software will automatically do it for you and plot it on the chart.
Also keep in mind that some charting software also provides additional pivot point features such as a third support and resistance level and intermediate levels or mid-point levels (levels in between the main pivot point and support and resistance level).
These “extra levels” aren’t as significant as the main five but it doesn’t hurt to pay attention to them. Here’s an example:
How to Trade with Pivot Points
Breakout Trades
The pivot point should be the first place you look at to enter a trade, since it is the primary support/resistance level. The biggest price movements usually occur at the price of the pivot point.
Only when price reaches the pivot point will you be able to determine whether to go long or short, and set your profit targets and stops. Generally, if prices are above the pivot it’s considered bullish, and if they are below it’s considered bearish.
Let’s say the price is hovering around the pivot point and closes below it so you decide to go short. Your stop loss would be above PP and your initial profit target would be at S1.
However, if you see prices continue to fall below S1, instead of cashing out at S1, you can move your existing stop-loss order just above S1 and watch carefully. Typically, S2 will be the expected lowest point of the trading day and should be your ultimate profit objective.
The converse applies during an uptrend. If price closed above PP, you would enter a long position, set a stop loss below PP and use the R1 and R2 levels as your profit objectives.
Range-bound Trades
The strength of support and resistance at the different pivot levels is determined by the number of times the price bounces off the pivot level.
The more times a currency pair touches a pivot level then reverses, the stronger the level is. Pivoting simply means reaching a support or resistance level and then reversing. Hence, the word “pivot”.
If the pair is nearing an upper resistance level, you could sell the pair and place a tight protective stop just above the resistance level.
If the pair keeps moving higher and breaks out above the resistance level, this would be considered an upside “breakout”. You would also get stopped out of your short order but if you believe that the breakout has good follow-through buying strength, you can reenter with a long position. You would then place your protective stop just below the former resistance level that was just penetrated and is now acting as support.
If the pair is nearing a lower support level, you could buy the pair and place a stop below the support level.
Theoretically Perfect?
In theory, it sounds pretty simple huh? Dream on, pal!
In the real world, pivot points don’t work all the time. Price tends to hesitate around pivot lines and at times it’s just ridiculously hard to tell what it will do next.
Sometimes the price will stop just before reaching a pivot line and then reverse meaning your profit target doesn’t get reached. Other times, it looks like a pivot line is a strong support level so you go long only to see the price fall, stop you out, then reverse back into your direction.
You must be very selective and create a pivot point trading strategy that you intend to strictly follow.
Let’s go look at a chart to see just how difficult and easy pivot points might be.
Ooooh pretty colors! We like...
Look at the orange oval. Notice how the PP was a strong support but if you went long on PP, it never was able to rise up to R1.
Look at the first purple circle. The pair broke down through PP but failed to reach S1 before reversing back to PP. On the second break down though (second purple circle), the pair did manage to reach S1 before once again reversing back to PP.
Look at the pink oval. Again, PP acted as strong support but never was able to rise up to R1.
On the yellow circle, the pair broke out to the downside again, sliced right through S1, and managed to fall all the way down to S2.
If you ever attempted to go long on this chart, you would have been stopped out every single time.
Personally, we would have not even thought about buying this pair - Why not? Well we have a little secret. What we didn’t show you regarding this chart was that this pair was trending down for quite some time now.
Remember the trend is your friend. We don’t like to backstab our friends, so we try our best to never trade against the trend.
In the next lesson, you will learn how to use multiple timeframes to trade with the correct trend direction so you’re able to minimize possible mistakes such as the one above.
Forex Pivot Point Trading Tips
Here are some easy to memorize tips that will help you to make smart pivot point trading decisions.
- If price at PP, watch for a move back to R1 or S1.
- If price is at R1, expect a move to R2 or back towards PP.
- If price is at S1, expect a move to S2 or back towards PP.
- If price is at R2, expect a move to R3 or back towards R1.
- If price is at S2, expect a move to S3 or back towards S1.
- If there is no significant news to influence the market, price will usually move from P to S1 or R1.
- If there is significant news to influence the market price may go straight through R1 or S1 and reach R2 or S2 and even R3 or S3.
- R3 and S3 are a good indication for the maximum range for extremely volatile days but can be exceeded occasionally.
- Pivot lines work well in sideways markets as prices will most likely range between the R1 and S1 lines.
- In a strong trend, price will blow through a pivot line and keep going.
Summary
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Pivot points are a technique used by professional traders and market makers to determine entry and exit points for the trading day based on the previous day’s trading activity. It’s best to use this technique after determining the direction of the trend.
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As the charts above show, pivots can be extremely useful in Forex since many currency pairs usually fluctuate between these levels.
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Range-bound traders will enter a buy order near identified levels of support and a sell order when the pair nears resistance.
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Pivot points also allow breakout traders to identify key levels that need to be broken for a move to qualify as a bona fide breakout.
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The simplicity of pivot points definitely makes them a useful tool to add to your trading toolbox. It allows you to see possible areas that are likely to cause price movement. You’ll become more in sync to market movements and make better trading decisions.
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Learn to use pivot points along with other technical analysis tools such candlestick patterns, MACD crossover, moving average crossovers, Stochastics overbought/oversold levels. The greater the confirmation, the greater your probability of success!
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