Pivot point analysis

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  1. Pivot Point Analysis: A Beginner's Guide

Pivot point analysis is a technical analysis method used to identify potential support and resistance levels in a financial market. It's a popular technique among traders because it's relatively simple to calculate and can be applied to various timeframes and asset classes, including stocks, forex, futures, and cryptocurrencies. This article provides a comprehensive guide to pivot point analysis for beginners, covering its history, calculations, types, applications, advantages, disadvantages, and integration with other technical analysis tools.

History and Origins

The concept of pivot points originated with Nicolas Darvas, a boxer-turned-investor who developed the system in the 1930s and 40s. Darvas sought a way to identify price levels that could indicate potential trading opportunities while he was traveling for boxing matches and couldn't constantly monitor the markets. He noticed that prices often reacted to certain key levels, and these levels could be calculated based on the previous day's trading range. His book, *How I Made Millions in Stocks*, detailed his methodology, and it has since become a cornerstone of technical analysis for many traders. While Darvas initially applied this to daily price movements, the technique has been adapted for intraday trading using shorter timeframes.

Core Concepts

At its heart, pivot point analysis relies on the idea that once a price breaks through a pivot point, it will likely continue moving in that direction. These pivot points act as psychological barriers that traders watch closely. The calculations are based on the previous period's high, low, and closing price. The 'previous period' can be a day for swing traders or an hour, 15 minutes, or even 5 minutes for day traders. The key is consistency in applying the timeframe.

The underlying principle is that these calculated levels represent areas where the market may experience a change in momentum. Traders use these levels to set entry and exit points, as well as to place stop-loss orders. Understanding the psychology behind these levels is crucial – many traders use similar calculations, creating self-fulfilling prophecies as they react to the same price points.

Calculating Pivot Points

The basic formula for calculating pivot points is as follows:

  • **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 a stock has the following data for the previous day:

  • High: $105
  • Low: $100
  • Close: $103

Using the formulas:

  • PP = (105 + 100 + 103) / 3 = 102.67
  • R1 = (2 x 102.67) - 100 = 105.34
  • R2 = 102.67 + (105 - 100) = 107.67
  • S1 = (2 x 102.67) - 105 = 100.34
  • S2 = 102.67 - (105 - 100) = 97.67

These values (102.67, 105.34, 107.67, 100.34, 97.67) represent the pivot point and the support and resistance levels that traders will monitor. Many trading platforms automatically calculate and display these levels on charts, simplifying the process for traders. Candlestick patterns can be used in conjunction with these levels for confirmation.

Types of Pivot Points

While the classic pivot point calculation is the most common, several variations have been developed to suit different trading styles and market conditions.

  • **Classic Pivot Points:** As described above, this is the original method developed by Nicolas Darvas.
  • **Fibonacci Pivot Points:** This method uses Fibonacci ratios to calculate the support and resistance levels. The formulas are:
   *   PP = (High + Low + Close) / 3
   *   R1 = PP + (0.382 x (High - Low))
   *   R2 = PP + (0.618 x (High - Low))
   *   S1 = PP - (0.382 x (High - Low))
   *   S2 = PP - (0.618 x (High - Low))
  • **Woodie's Pivot Points:** Developed by Woodie Adey, this method uses a more complex calculation involving multiple pivot points and filters to identify high-probability trading setups. It incorporates concepts like the "Tom DeMark" count and considers the overall trend. This is a more advanced technique.
  • **Junichi Sentimental Pivot Points:** This method incorporates the closing price more heavily, reflecting the sentiment of the market close. It uses different formulas for bullish and bearish closes.

The choice of which type to use depends on your trading strategy and the specific market you are trading. Moving averages can be used alongside pivot points to filter out false signals.

Applications in Trading

Pivot point analysis can be used in a variety of ways:

  • **Identifying Entry Points:** Traders often look for price breakouts above resistance levels or below support levels as potential entry signals. A breakout suggests that the price is likely to continue moving in that direction.
  • **Setting Profit Targets:** Pivot point levels can be used as potential profit targets. For example, if you buy after a breakout above R1, you might set R2 as your initial profit target.
  • **Placing Stop-Loss Orders:** Pivot point levels can also be used to set stop-loss orders. For example, if you buy after a breakout above R1, you might place a stop-loss order just below R1 to limit your potential losses.
  • **Determining Trend Direction:** The relationship between the price and the pivot point levels can provide clues about the trend direction. If the price consistently breaks above resistance levels, it suggests an uptrend. If it consistently breaks below support levels, it suggests a downtrend. Trend lines can confirm these observations.
  • **Intraday Trading:** Pivot points are particularly useful for intraday traders, who rely on short-term price movements. Shorter timeframes (e.g., 5-minute, 15-minute) are commonly used for calculating pivot points in intraday trading.

Integrating with Other Technical Indicators

Pivot point analysis is most effective when used in conjunction with other technical analysis tools. Here are some examples:

  • **Volume:** Confirming breakouts with high volume increases the probability of a successful trade. Low volume breakouts can be false signals.
  • **Relative Strength Index (RSI):** Using the RSI can help identify overbought and oversold conditions, potentially indicating when a breakout is likely to fail.
  • **Moving Averages:** Comparing the price to moving averages can help confirm the trend direction and identify dynamic support and resistance levels.
  • **MACD (Moving Average Convergence Divergence):** The MACD can provide additional confirmation of trend direction and momentum. A bullish MACD crossover can support a breakout above a resistance level.
  • **Bollinger Bands:** Bollinger Bands can help identify volatility and potential breakouts.
  • **Fibonacci Retracements:** Combining Fibonacci retracements with pivot points can pinpoint precise entry and exit points.
  • **Support and Resistance Levels:** Pivot points can be used to confirm existing support and resistance levels identified through other methods.
  • **Chart Patterns:** Chart patterns like head and shoulders, double tops/bottoms, and triangles often form around pivot point levels.
  • **Elliott Wave Theory:** Pivot points can help identify potential wave targets and retracements within the framework of Elliott Wave Theory.
  • **Ichimoku Cloud:** The Ichimoku Cloud provides a comprehensive view of support, resistance, and trend direction, complementing pivot point analysis.

Advantages of Pivot Point Analysis

  • **Simplicity:** The calculations are relatively straightforward, making it easy for beginners to learn and apply.
  • **Objectivity:** The levels are calculated based on mathematical formulas, reducing subjectivity.
  • **Versatility:** The technique can be applied to various timeframes and asset classes.
  • **Self-Fulfilling Prophecy:** Because many traders use pivot points, they often act as self-fulfilling prophecies, creating predictable price reactions.
  • **Clear Entry and Exit Points:** Pivot points provide clear levels for setting entry and exit points, as well as stop-loss orders.

Disadvantages of Pivot Point Analysis

  • **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 sometimes break through pivot point levels temporarily before reversing direction, resulting in false signals.
  • **Market Noise:** In choppy or volatile markets, pivot point levels can be less reliable.
  • **Not a Standalone System:** Pivot point analysis should not be used in isolation. It’s best used in conjunction with other technical indicators and risk management strategies.
  • **Subjectivity in Timeframe Selection:** While the calculations are objective, the choice of timeframe (daily, hourly, etc.) can be subjective and impact the results. Japanese Candlesticks require careful interpretation.
  • **Gaps:** Significant gaps in price action can invalidate pivot point levels.
  • **Limited Predictive Power:** Pivot points identify *potential* areas of support and resistance, but they don't guarantee that the price will react as expected. Backtesting is crucial to validate any strategy.
  • **Requires Confirmation:** Breakouts need to be confirmed with volume and other indicators.
  • **Market Manipulation:** In certain markets, large players can manipulate prices to trigger breakouts or fakeouts at pivot point levels.
  • **Dynamic Markets:** Fast-moving and highly dynamic markets can render pivot points obsolete quickly.


Risk Management Considerations

Regardless of the technical analysis method used, proper risk management is crucial for successful trading. Always use stop-loss orders to limit your potential losses. Never risk more than a small percentage of your trading capital on a single trade (typically 1-2%). Consider your risk tolerance and adjust your trading strategy accordingly. Position sizing is a key component of risk management.

Further Learning Resources



Technical Analysis Support and Resistance Trading Strategy Risk Management Candlestick Chart Forex Trading Stock Trading Day Trading Swing Trading Market Psychology

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