Historically, pivot points are one of the most popular technical tools used by Forex traders, regardless of their level of experience in the markets. Essentially a price level which indicates the market’s direction (or sentiment), pivot points are indicators represented by a line on a price chart that divides support and resistance. If used properly, as the FXTM Head of Education Andreas Thalassinos explains below, they can be an essential tool for traders.
What are Pivot Points, exactly?
Put simply, pivot points (PP) are benchmarks that traders use to get a feel for the way the market is moving; whether the financial instrument they’re trading has a bullish or a bearish inclination. A bearish sentiment is formed when the price goes below the PP level, and in contrast, the bulls are in play if the price goes beyond the PP level.
To calculate PP, 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:
Pivot Point (PP) = (Previous High + Previous Low + Previous Close) / 3
Once the PP is found, resistance (R1, R2 and R3) and support (S1, S2 and S3) levels are calculated as follows:
R3 = High + 2*(PP – Low)
R2 = PP + High – Low
R1 = 2*PP – Low
S1 = 2*PP – High
S2 = PP – (High – Low)
S3 = Low – 2*(High-PP)
Depending on the movement of the price, each resistance and support level can adopt the role of a pivot point. So, for example, if the price breaks through the R1 barrier then traders can feel confident that it’s a bullish market and the opportunity for potential profit increases. If the price continues upward, R1 essentially becomes the support to R2, which takes on the role of R1, and so forth.
By contrast, if the price moves below PP, then all eyes are on S1, while PP essentially turns into R1. If prices oscillate within this narrow space, between PP and S1, forex traders may find themselves buying at S1 and selling at PP.
Here’s another important tip: if the market is looking bullish, a stop loss order below R1 would provide potential protection from unexpected movements in price. After all, there is no technical tool in this world that can guarantee with absolute certainty what direction the market will move in!
Pivot Point Methods
While most traders and Forex investors use the Standard method (described above) to calculate PP, another four methods are used by technical traders today. These are Fibonacci, DeMark’s, Woodie’s and Camarilla.
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. 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.
The distance between every level (be it PP, S or R) depends on the method used for calculation, and as such, how much reliance is placed on each level differs in relation to the formula. Thus, giving a fitting amount of weight to market sentiment can become tricky for both experienced and novice traders. Taking this into account, FXTM has developed a Pivot Points Strategy as an educational tool which doesn’t rely solely on pivot point calculations to determine market direction and sentiment. Using data from three widely used indicators – the MACD (Moving Average Convergence Divergence), Momentum and Moving Average – the goal of the tool is to give the trader a clearer overall picture of the market, so that he (or she) can make more informed decisions.
Using Pivot Points in Forex Trading
When studying Forex trading, you may have come across the term “pivot points.” This is a collection of support and resistance that is calculated ahead of time to give you an idea as to where to buy and sell a currency pair. Pivot points aren’t solely used in Forex, and in fact, have history in the futures pits in America. This harkens back to the days of open outcry trading, and pre-computer days.
Unlike many other indicators that you will come across, pivot points are, by their very nature, predictive. Essentially, what you are doing is seeing where the overall pivot in the market can be, and then the next three support and the next three resistance levels. This indicator is quite powerful, but like many other indicators should be confirmed by either price action or other factors such as a previous support level.
The study of pivot points focuses on the relationships between the high, low, and closing prices between each trading day. In other words, the previous trading day’s prices are used to calculate the pivot point for the current day. The pivot point itself, the central focus of the indicator, is considered to be “fair value” for the market going into the session. Remember, if price is rising and has turned around, it is said to have ran into resistance. Alternately, if price is falling and has turned around, it is said to have met support. This indicator will plot out what the “fair value” of the market is, and then three potential areas in both directions called support one, support two, support three, and alternately resistance one, resistance two, and resistance three to act as guidelines.
The calculation for the pivot point of the day is equal to the high of the previous session added to the low of the previous session and the close of the previous session. Dividing these three numbers by three gives you the point. By knowing the pivot point, then you can extrapolate S1, S2, S3, R1, R2, and R3.
Pivot Point for current session = High (previous session) + Low (previous) + Close (previous)
The rest of the pivot points can be calculated as following:
Resistance 1 = (2 x Pivot Point) – Low (previous period)
Support 1 = (2 x Pivot Point) – High (previous period)
Resistance 2 = (Pivot Point – Support 1) + Resistance 1
Support 2 = Pivot Point – (Resistance 1 – Support 1)
Resistance 3 = (Pivot Point – Support 2) + Resistance 2
Support 3 = Pivot Point – (Resistance 2 – Support 2)
One of the main reasons that traders use pivot points is that statistically, they have worked out. For example, the EUR/USD pair has printed a low for the day under S1 roughly 44 percent of the time. The high of the day has been above R1 roughly 42 percent of the time, while the low has been lower than S2 merely 17 percent of the time. Going forward, R2 has been breached by the highs of the day only 17 percent of the time, while the lows and highs breaking above or below S3 and R3 only occurs roughly 3 percent of the time. Because of this, you can get a feel for how likely price is to go to one of these areas. Think of it like a bell curve, and the standard deviation equations you learned in school. Once you get beyond two standard deviations, it’s very rare that you stay there, you can think of our three and S3 very much like that.
Think of it this way; if the R1 level is only broken above roughly 42 percent of the time, then that means that if you are short of the market, the odds are on your side if you put the stop loss above resistance one. Obviously, there’s an entire combination and a plethora of possibilities here.
Luckily, most trading platforms now include pivot points, so you won’t necessarily need to know how to do the calculations.
An example in action
The attached chart of the AUD/USD pair on the hourly timeframe has the pivot point indicator attached to it. At this point, I would point out that not all MetaTrader platforms come with it, but there are free downloads available online in a multitude of schemes. In this particular set up, the pivot point from the previous day is the yellow line, while the support levels are blue, and the resistance levels are red. As you look at this chart, notice that the market started the day much lower than the pivot. The central pivot line, the yellow line, should be thought of as potential “fair value” for the market. Instead of starting there, we started at S1, and started seeing support. You can see clearly that we initially moved towards the pivot point, but then broke higher. You will notice that we stalled at R1, where we closed the day.
You can see the importance of these levels on this chart, because even when they get broken the next level will start to show its influence. What I have not pointed out on this chart is that the central pivot is at the 0.73 level, an area that has been both support and resistance more than once. That is why is not a huge surprise to see that the market slammed into that level and did not break through it right away. If you had decided to go long of the market based upon S1, you probably would have taken profit near the pivot point. Beyond that, if we break out to the upside as happened, then you could very well look to the area just below the pivot point to place a stop loss. While not in and of itself a trading system, pivot points do work on statistical probability, something that a lot of quantitative trading is based on. Keep in mind that a lot of machines are trading currencies these days, so these ratios and formulas certainly can come into play. So by using pivot points and Forex trading, you are adding a bit of quantitative trading to your strategy.
Pivot points are typically used for shorter-term trading, but there are pivot points out there that are used for monthly time frames as well. When calculating those, simply replace the high, low, close values of the previous session with the previous month. It works the same way, in any timeframe.