School of Pipsology - Pivot Points

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  1. School of Pipsology - Pivot Points

Introduction

Pivot Points are a technical analysis tool used by traders to identify potential support and resistance levels. Developed by floor traders, these levels are calculated using the previous day’s high, low, and closing prices. They offer a clear, objective method for anticipating potential price movements, providing entry and exit points, and setting stop-loss orders. This article, geared towards beginners, will delve into the intricacies of Pivot Points, covering their calculation, interpretation, practical application, and limitations. Understanding Pivot Points is a foundational step in mastering Technical Analysis, and complements other indicators like Moving Averages and Fibonacci Retracements.

History and Origin

Pivot Points originated with floor traders on exchanges like the New York Stock Exchange (NYSE). Before the widespread availability of computerized charting, these traders needed a quick and easy way to identify key price levels. They used simple calculations based on the previous day’s price action to establish these levels, which served as benchmarks for their trading decisions. The system proved effective in identifying areas where prices were likely to find support or encounter resistance. The concept has since been adopted by modern traders, fueled by the ease of automated calculation through trading platforms and software. It’s important to remember that Pivot Points are a derivative of price action itself, making them a valuable tool within a broader Price Action Trading strategy.

Calculating Pivot Points

The core of Pivot Points lies in their calculation. While variations exist (discussed later), the standard formula is based on the previous day's (or period’s) high, low, and close. Here's how it's done:

  • Pivot Point (PP): (High + Low + Close) / 3
  • Resistance Level 1 (R1): (2 x Pivot Point) - Low
  • Resistance Level 2 (R2): Pivot Point + (High - Low)
  • Support Level 1 (S1): (2 x Pivot Point) - High
  • Support Level 2 (S2): Pivot Point - (High - Low)

Let's illustrate with an example:

Assume yesterday's prices were:

  • High: 1.1050
  • Low: 1.0900
  • Close: 1.1000

Calculations:

  • PP = (1.1050 + 1.0900 + 1.1000) / 3 = 1.0983
  • R1 = (2 x 1.0983) - 1.0900 = 1.1066
  • R2 = 1.0983 + (1.1050 - 1.0900) = 1.1133
  • S1 = (2 x 1.0983) - 1.1050 = 1.0916
  • S2 = 1.0983 - (1.1050 - 1.0900) = 1.0833

These calculated levels (PP, R1, R2, S1, S2) are then plotted on a price chart. Most trading platforms offer automatic Pivot Point calculations, eliminating the need for manual computation. Understanding the formula, however, reinforces the logic behind the levels. This is crucial when considering variations and customizations. See also Candlestick Patterns for complementary trading signals.

Interpreting Pivot Points

Once plotted, Pivot Points act as potential areas of support and resistance.

  • Support Levels (S1 & S2): These levels are areas where the price might find buying pressure, preventing further declines. Traders often look to buy near these levels, anticipating a bounce.
  • Resistance Levels (R1 & R2): These levels are areas where the price might encounter selling pressure, preventing further advances. Traders often look to sell near these levels, anticipating a reversal.
  • Pivot Point (PP): The Pivot Point itself often acts as a level of either support or resistance, depending on the prevailing trend. If the price is above the PP, it often acts as support. If the price is below the PP, it often acts as resistance. This is a key concept in Trend Following.

It's crucial to remember that Pivot Points are *potential* levels, not guarantees. Price action doesn't always respect these levels, and false breakouts can occur. Therefore, they should be used in conjunction with other technical indicators and risk management strategies. Chart Patterns can often confirm or contradict Pivot Point signals.

Practical Applications in Trading

Pivot Points offer a wide range of practical applications for traders:

  • Identifying Entry Points: Traders might look to enter long positions (buy) when the price bounces off a support level (S1 or S2). Conversely, they might look to enter short positions (sell) when the price is rejected by a resistance level (R1 or R2).
  • Setting Stop-Loss Orders: A common strategy is to place a stop-loss order just below a support level for long positions or just above a resistance level for short positions. This limits potential losses if the price moves against the trade.
  • Setting Profit Targets: Traders might set profit targets at the next resistance level for long positions or the next support level for short positions.
  • Determining Trend Strength: If the price consistently breaks through resistance levels, it suggests a strong uptrend. Conversely, if the price consistently breaks through support levels, it suggests a strong downtrend. This aligns with the principles of Elliott Wave Theory.
  • Combining with Other Indicators: Pivot Points work well with other indicators. For example, combining them with Relative Strength Index (RSI) can help confirm overbought or oversold conditions near Pivot Point levels. Using them with MACD can validate trend direction.

Example Scenario:

A trader notices the price is approaching S1 (1.0916 in our previous example). They also observe bullish Momentum Indicators. They decide to enter a long position at 1.0920, placing a stop-loss order just below S1 at 1.0910 and a profit target at R1 (1.1066).

Variations of Pivot Points

While the standard Pivot Point calculation is the most common, several variations exist:

  • Fibonacci Pivot Points: These use Fibonacci ratios to calculate the support and resistance levels, often considered more accurate by some traders. They incorporate the Golden Ratio.
  • Woodie's Pivot Points: Developed by Woodie Adey, these use different calculations and emphasize the importance of the Pivot Point itself as a key level.
  • Classic Pivot Points: These are the standard calculations outlined above.
  • Monthly, Weekly, and Daily Pivot Points: Pivot Points can be calculated for different timeframes. Monthly Pivot Points provide long-term support and resistance levels, while weekly and daily Pivot Points offer shorter-term levels. Choosing the appropriate timeframe depends on the trader's style and strategy.
  • Pivot Point Ranges: Some traders focus on the range between the Pivot Point and the resistance/support levels, looking for breakouts or reversals within these ranges.

Experimenting with different variations can help traders find the ones that best suit their trading style and the specific market they are trading. Backtesting is crucial when implementing new variations. See Backtesting Strategies for more information.

Limitations of Pivot Points

Despite their usefulness, Pivot Points have limitations:

  • Self-Fulfilling Prophecy: Because many traders use Pivot Points, the levels can become self-fulfilling prophecies. If enough traders place orders around these levels, the price might react accordingly, regardless of underlying fundamentals.
  • Lagging Indicator: Pivot Points are based on past price data, making them a lagging indicator. They may not always accurately predict future price movements.
  • False Breakouts: Prices can temporarily break through Pivot Point levels before reversing, leading to false signals. This is why stop-loss orders are essential.
  • Not Effective in All Markets: Pivot Points may be more effective in trending markets than in choppy or sideways markets.
  • Subjectivity in Timeframe Selection: Choosing the appropriate timeframe for Pivot Point calculation can be subjective and influence the results.

Addressing these limitations requires combining Pivot Points with other analytical tools and implementing robust risk management strategies. Consider incorporating Volume Analysis to confirm Pivot Point breakouts.

Risk Management with Pivot Points

Effective risk management is paramount when trading with Pivot Points. Key strategies include:

  • Stop-Loss Orders: Always use stop-loss orders to limit potential losses. Place them just below support levels for long positions and just above resistance levels for short positions.
  • Position Sizing: Determine the appropriate position size based on your risk tolerance and the distance to your stop-loss order.
  • Confirmation Signals: Don't rely solely on Pivot Points. Look for confirmation signals from other indicators or chart patterns before entering a trade.
  • Avoid Overtrading: Don't force trades based on Pivot Points if the market conditions are unfavorable.
  • Backtesting and Analysis: Thoroughly backtest your Pivot Point strategies to assess their historical performance and identify potential weaknesses. Reviewing past trades (a Trading Journal is invaluable) can also provide insights.

Advanced Concepts

  • Pivot Point Confluence: When Pivot Points from different timeframes align, it creates a stronger level of support or resistance.
  • Pivot Point Breakout Strategies: Trading breakouts of Pivot Point levels can be a profitable strategy, but requires careful risk management and confirmation signals.
  • Dynamic Pivot Points: Adjusting Pivot Point calculations based on market volatility and changing conditions can improve their accuracy.
  • Using Pivot Points in Conjunction with Price Patterns: Identifying harmonic patterns that intersect with Pivot Point levels can increase the probability of successful trades.

Resources for Further Learning


Technical Indicators Support and Resistance Chart Analysis Trading Strategies Risk Management Forex Trading Stock Trading Commodity Trading Currency Pairs Trading Psychology

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