Pivot points are a darling to most traders and are undoubtedly one of the most popular technical tools used by Forex traders, regardless of their level of experience in the markets. Essentially pivot points are a price level which indicates the market’s sentiment or direction.
This article seeks to unpack the pivot points and how they can be of use to traders. This will be done through defining what pivot points and the calculation thereof and how the various pivot point types can be of use to the trader.
What are Pivot Points?
Pivot points can be defined as a technical analysis indicator used to determine the overall trend of the market over different time frames. It can be put simply as benchmarks that traders use to get a feel for the way the market is moving. A bearish sentiment is formed when the price goes below the pivot point level, and in contrast, the bulls are in play if the price goes beyond the pivot point level.
Support levels are levels where the price tends to find support as it falls. That is, the price at which it is more likely to "bounce" off this level rather than break through it. However, in the event of a break through, by an amount exceeding some noise, it is likely to continue falling until meeting another support level.
Resistance levels are the levels where the price tends to find resistance as it rises. Again, this means that the price is more likely to "bounce" off this level rather than break through it.
Calculation of pivot points and the corresponding support and resistance levels.
To calculate pivot points a mean average of the high, low and close prices is taken from the last completed candlestick formation. Here’s what the formula looks like:
Once the pivot point is found, resistance (R1, R2 and R3) and support (S1, S2 and S3) levels are calculated as follows:
This can be shown graphically as shown in Fig 1 below.
Fig 1: Graphical representation of pivot points.
Thankfully traders do not have to go through such rigorous computations as most trading platforms come with the indicators. However, knowing the calculation behind the indicators will make the trader’s appreciation of the whole concept of pivot points much better.
Pivot Point Methods
While most traders and Forex investors use the Standard method as is described above to calculate pivot points, another four methods are used by technical traders today namely Fibonacci, DeMark’s, Woodie’s and Camarilla. On the Dukascopy website the various pivot points are given for the various instruments with the exception of the DeMark’s pivot points. The link to the pivot point is Pivot Point Levels.
On the trading platform the same pivot points can be found in the indicators section. Fig 2 is a screenshot of the available pivot point methods on the Dukascopy trading platform.
Fig 2: Various pivot point methods on the Dukascopy trading platforms
The Standard, Fibonacci and Woodie’s methods are similar in their formulas because all three take the previous period’s high, low and close prices into consideration whilst Camarilla is different in that it also factors in the current period’s open price, while the formula for DeMark’s depends on the relationship between the previous period’s open and close price and does not take the main PP into consideration.
Trading Based on Support and Resistance
The basic trading method for using support and resistance is to buy near support in a bullish market and range bound market, and to sell near resistance in downtrends and ranges. The trend provides guidance on the direction to trade in. For example, if the trend is down but then a range develops, preference should be given to short-selling at range resistance instead of buying at range support. The downtrend lets us know that going short has a better probability of producing a profit than buying. Buying near support or selling near resistance can pay off, but there is no assurance that the support or resistance will hold. Therefore, consider using this method in conjunction with other indicators.
As a risk management tool, when buying, place a stop loss several cents below support, and when shorting place a stop loss several cents above resistance. This means that when entering a trade, have a target price in mind for a profitable exit. If buying near support, consider exiting just before the price reaches a strong resistance level. If shorting at resistance, exit just before the price reaches strong support.
Adapt Trading Decisions to New Support and Resistance Levels
Trading is a continuous process and as such support and resistance are dynamic, and the trading decisions must also reflect this. In an uptrend, the last low and last high are what is important. If the price makes a lower low it indicates a potential trend change, but if the price makes a new high that helps confirm the uptrend. Focus your attention on the support and resistance levels that matter at that particular moment in time. Trends often bounce off at strong areas. They may eventually break through, but it often takes time and multiple attempts. Therefore it is important to mark major support and resistance levels on your chart, as they could become relevant again in the future if the price approaches those areas.
In the world of trading there is no perfect indicator and no perfect strategy, therefore in making use of these indicators it is imperative that one has a proper understanding of their functionality. Various indicators also complement each other and it is important to make use of these to make sure that the correct trading decision is made. Above all money management is of paramount importance. Therefore no matter how confident a trader is on a trade, it is crucial that a stop loss be placed to maximise the risk reward payoff.