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Pivot Points
The pivot point is the level at which the market direction is thought to change for the day. Using some simple arithmetic and the previous days high, low and close, a series of points are derived. These points can be critical support and resistance levels. The pivot level, support and resistance levels calculated from that are collectively known as pivot levels.
The reason pivot points are so popular is that they are predictive as opposed to lagging. You use the information of the previous day to calculate potential turning points for the day you are about to trade (present day).
A simple formula to calculate pivot points is as follows:
( High, Low, and Close refer to Daily Data )
Resistance 3 = High + 2*(Pivot - Low)
Resistance 2 = Pivot + (R1 - S1)
Resistance 1 = 2 * Pivot - Low
Pivot Point = ( High + Close + Low )/3
Support 1 = 2 * Pivot - High
Support 2 = Pivot - (R1 - S1)
Support 3 = Low - 2*(High - Pivot)
The general idea behind trading pivot points are to look for a reversal or break of R1 or S1. By the time the market reaches R2,R3 or S2,S3 the market will already be overbought or oversold and these levels should be used for exits rather than entries.
A perfect set would be for the market to open above the pivot level and then stall slightly at R1 then go on to R2. You would enter on a break of R1 with a target of R2 and if the market was really strong close half at R2 and target R3 with the remainder of your position.
Unfortunately life is not that simple and we have to deal with each trading day the best way we can.
I have picked a day at random from last week and what follows are some ideas on how you could have traded that day using pivot points.
the 12th August 04 the Euro/Dollar (EUR/USD) had the following:
High - 1.2297
Low - 1.2213
Close - 1.2249
This gave us:
Resistance 3 = 1.2377
Resistance 2 = 1.2337
Resistance 1 = 1.2293
Pivot Point = 1.2253
Support 1 = 1.2209
Support 2 = 1.2169
Support 3 = 1.2125
Have a look at the 5 minute chart below
The green line is the pivot point. The blue lines are resistance levels R1,R2 and R3. The red lines are support levels S1,S2 and S3.
There are loads of ways to trade this day using pivot points but I shall walk you through a few of them and discuss why some are good in certain situations and why some are bad.
The Breakout Trade
At the beginning of the day we were below the pivot point, so our bias is for short trades. A channel formed so you would be looking for a break out of the channel, preferably to the downside. In this type of trade you would have your sell entry order just below the lower channel line with a stop order just above the upper channel line and a target of S1. The problem on this day was that, S1 was very close to the breakout level and there was just not enough meat in the trade (13 pips). This is a good entry technique for you. Just because it was not suitable this day, does not mean it will not be suitable the next day.
The Pullback Trade
This is one of my favorite set ups. The market passes through S1 and then pulls back. An entry order is placed below support, which in this case was the most recent low before the pullback. A stop is then placed above the pullback (the most recent high - peak) and a target set for S2. The problem again, on this day was that the target of S2 was to close, and the market never took out the previous support, which tells us that, the market sentiment is beginning to change.
Breakout of Resistance
As the day progressed, the market started heading back up to S1 and formed a channel (congestion area). This is another good set up for a trade. An entry order is placed just above the upper channel line, with a stop just below the lower channel line and the first target would be the pivot line. If you where trading more than one position, then you would close out half your position as the market approaches the pivot line, tighten your stop and then watch market action at that level. As it happened, the market never stopped and your second target then became R1. This was also easily achieved and I would have closed out the rest of the position at that level.
Notes and references
- http://www.tradejuice.com/forex/pivot-point-trading-mm.htm
See also
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