What are pivot points?
The phrase “pivot points” in relation to Forex trading is often misunderstood. Many traders believe it refers only to the daily pivot point, calculated as an average of: the high, the low and the closing price of a security, based on the previous day’s trading. However, pivot points (PP) also include both resistance and support calculations and the three ‘traditional’ levels; R1-R3 and S1-S3.
The words “support” and “resistance” will become very familiar to novice traders as their careers evolve. The concept behind the use of support and resistance is one of the most important aspects of method, which traders need to familiarize themselves with and they need to get up to speed with the theory, in as short a period of time as possible.
If traders decide not to use pivot points (PP), support and resistance directly in their trading method and overall strategy, PP analysis can still provide an invaluable tool for decision making. For example; they may be swing traders holding trades over days, therefore knowing if conditions regarding the Forex pair, or other security you’re trading, are either bearish or bullish (on a daily basis), can provide a valuable observation and motivate traders were their decision making is concerned. As a simple example; as a swing trader you might consider adjusting your stop in order to lock in profits, as you’re concerned a reversal in trend may be developing.
Bullish, Bearish, Open, High and Close
The simplest explanation and description of pivot points would be a horizontal daily ‘trend’ line on our charts, illustrating the starting point for price on any given day, combined with horizontal trend-lines, demonstrating when market conditions are perceived to be either bullish, or bearish. If price pushes up through R1, then daily trading conditions for that security could be described as “bullish”. If price falls through S1, then daily conditions could be described as “bearish”.
Pivot point (PP) = (High + Low + Close) / 3 is the raw accepted, standard calculation used by who we’d term Chartists, in order to determine where to a place our daily pivot point level and our other pivot point levels, on our chart. Fortunately, the majority of charting packages such as MetaTrader4 have simple tools, allowing you to place the pivot point automatically, without having to manually calculate them and place them on your chart each day. As a 24 hour market the daily close for our Forex market, is traditionally identified as the New York trading session closing; 4pm EST.
Different Pivot Point Calculations
As with many indicators there has been the tendency for traders to experiment with and adjust the Classic standard pivot point calculations. Therefore, we now have an array of options; Classic (standard), Fibonacci, Woodie, DeMark’s and Camarilla pivot points. We’d suggest that traders DYOR (do your own research) as to the efficiency of the alternatives to the Classic pivot points. Similarly, settings can be altered on all the PP calculations, again we’d politely suggest traders should investigate the potential of altering the settings, beyond the accepted standard. For discussion purposes in this article, we’ll only be referencing the Classic pivot points’ and the standard metrics.
Image via Kbrose/Wikimedia/Wikimedia
Are Pivot Points Leading Indicators
We often refer to indicators being “lagging”, or “leading”, many technical indicators we use lag; they mathematically react only to the behaviour of price and if you’re trading off and making your decisions from a daily chart, then the indicator information will inevitably lag. However, many Chartists regard pivot points as leading indicators, because they can be perceived as a predictive indication of where price may be headed. Moreover, if left in their Classic form with no settings’ adjustment and therefore calculated each day, they’re effectively primed to: illustrate immediate price action, bullish and bearish conditions each day and demonstrate where price may be headed. The Pinot Points are pivotal to many trading concepts and are often breached during periods of intense volatility, easily recognized by standard price action candlestick patterns of behaviour. Therefore the conclusion could be reached that PP are leading indicators.
Self Fulfilling Prophecy
Similar to discussions surrounding the efficiency of using Fibonacci retracement in any trading method, critics of pivot point trading strategies would suggest that they’re both self fulfilling prophecies. This may be relevant to Fibonacci, however, when traders consistently observe price breaching support and resistance levels on a regular basis, the self fulfilling prophecy idea begins to fall apart. The suspicion could relate to the idea that many traders in institutions, who actually move our Forex markets, place their: buy, sell, stop and take profit limit orders around the key pivot point levels.
There’s one critical aspect relating to PP that possibly debunks the self fulfilling prophecy claim; PP are steadfast throughout the day. They don’t adjust with market conditions, they’re permanent lines in the sand on our charts that when crossed historically, when measured over a significant representative period, undoubtedly illustrate bearish and or bullish market conditions.
Mind the Gaps
There are times when traders need to be extremely vigilant when using pivot points in their trading; firstly, when markets open on Sunday evening/Monday morning the gaps between pivot points can narrow considerably, as on many charting packages the software can become confused, calculating the H,L,C, of the previous day (Sunday) and not the preceding Friday’s data. Similarly markets opening with “gaps” can result in resistance and support pivot points being breached immediately, or shortly after the market opens. This can offer up tremendous trading opportunities for the highly experienced, but leave the inexperienced bemused, frustrated and suffering rapid and unnecessary account losses.
Secondly, different charting packages can calculate the pivot points depending on the time zone the trader is operating from/living in; many packages don’t adhere to (for example), London GMT time and the 4pm New York closing time, generally accepted as being the ‘official’ standards for the opening and closing of the market. Therefore it’s essential that traders, if using the classic/standard pivot point calculations, establish the precise numeracy of the points. It’s critical that traders use the same calculation method that is predominantly used throughout the Forex industry.
Reading Between the Lines
There are many basic trading strategies that Forex traders can identify and modify, in order to suit their personal trading preferences, by using the pivot points. Using R1, or S1 allows traders to establish daily trends, in terms of bullish and bearish market conditions. Traders may therefore decide to develop a trading strategy of only “going long” if price is above R1, or “going short” if price is below S1. Certainly there are many proven strategists that’ll testify to the efficacy and profitability of only trading “with trend”, even if it’s a short term, identifiable trend.
Traders could decide to place market orders ‘between the lines’, for example; as price moves up through the daily pivot to reach R1, traders might attempt to capture that move, or place an order between R1 – R3, whilst using trailing stops to perhaps lock in profits.
Price Action
Traders might have one eye on the economic calendar, be aware of the precise time a high impact data publication is released. As a consequence the may be primed to observe price action, whether bullish or bearish, which might also take price into the ‘zones’ of R1-R3 or S1-S3. Incorporating candlestick, price action, pattern analysis into your support and resistance trading method, can also help identify trading opportunities. As an example, if we observe aDOJI candlestick (often indicating indecision and lack of sentiment direction) has formed over S1, or that for example the RSI is indicating oversold conditions, then S1 may hold as support.
3,2,1, Let’s Go…
Let’s finish with some trading ideas and overall observations surrounding the use of our S1-S3 and R1-R3 pivot points and how they can prove to be pivotal to our potential trading success. These ideas should in no way be regarded as trading suggestions, think of them as a brain storm of the different uses of this critical trading tool. As always; no method is bombproof, no strategy is 100% certain, as the one certainly we can point to in our world of trading is uncertainty.
Firstly pivoting could be translated as reaching a support, or resistance level and then reversing; price is considered to be rejecting the level. This may give an indication that collective trader sentiment is not strong enough to break through the level. For example; if price hits S1 or R2 regularly throughout the trading day, but fails to break through and instead reverses, this could be translated as a lack of strength of commitment, on behalf of traders and investors. If price breaks through, for example, R1, then R2, then R3, it could be indicating extreme bullish conditions for the Forex pair, in turn this could be considered a continuation of a strong trend already developed, or a major reversal point from bearish, or ‘neutral’, to bullish conditions.
Traders who use what we term “range bound indicators” to base their trading strategy on, may use pivot points to identify possible reversal points, placing orders at these critical levels forms part of many traders’ strategies. Whilst “break out” traders may use pivot points to identify times and key levels when price has broken out of a range, therefore a new trend may be developing.
Traders may place speculative ‘rejection’ orders at R3 or S3, believing that price will always reject these extreme levels (temporarily or otherwise) and place their take profit limit orders at the next levels of R2 or S2. Traders may place orders between the daily pivot point and the first level of R or S.
The exciting list of possibilities using primarily PP as a trading strategy, are limitless, however, any method is only as good as the strict money management and risk parameters we attach to our trading methods. Similarly it’s imperative that we recognize that no systems are perfect; if you attempt a pivot point trading strategy and it doesn’t work on a particular trading day, that doesn’t necessarily prove that the method is unworkable. This is where back-testing, forward-testing and the simple act of using a demo account, running parallel to your real trading account, become invaluable.
Shhh, it could be the holy grail, but not as you imagined it.
We can spend years trying the most intricate trading strategy, which lights up like November 5th or July 4th on our charts, when the simplest explanation and “holy grail” of trading has been staring you in the face and its not how you imagined it. Pivot point trading can be like that; it’s not a 100% strategy, but when you strip our trading down to its most: effective, efficient, bare bones, return on investment and time opportunity, it’s possibly as good as it will ever get.
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