The pivot point and its derivatives are a tool that provides forex traders with potential support and resistance levels and helps minimize risk. Using reference points such as support and resistance helps determine when to enter the market, place stops and take profits. However, many newbie traders pay too much attention to technical indicators, including the Moving Average Convergence Divergence (MACD) and Relative Strength Index (RSI). While useful, these indicators fail to identify a point that defines risk. Unknown risk can lead to margin calls, but calculated risk greatly improves the chances of long-term success.
In this article, we will explain why a combination of pivot points and traditional technical tools is more powerful than technical tools alone, and show the usefulness of pivot points in the forex market.
Pivot Points 101
A pivot point is used to reflect a change in market sentiment and to determine overall trends over a time frame, as if it were hinges from which trade swings up or down. Originally employed by floor traders in stocks and futures, they are now most often used in conjunction with support and resistance levels to confirm trends and minimize risk.
Similar to other forms of trendline analysis, pivot points focus on important relationships between high, low, and closing prices between trading days; i.e. the previous day’s prices are used to calculate the pivot point for the current trading day. Although they can be applied to almost any trading instrument, pivot points have proven to be exceptionally useful in the foreign exchange (FX) market, especially when trading currency pairs.
Forex markets are highly liquid and trade with very high volume attributes which reduce the impact of market manipulation which could otherwise inhibit the support and resistance projections generated by pivot points.
Support and resistance levels
While pivot points are identified based on specific calculations to help spot important resistance and resistance levels, support and resistance levels themselves rely on more subjective placements to help spot potential opportunities. small group negotiation.
Support and resistance lines are a theoretical construct used to explain traders’ apparent reluctance to push the price of an asset past certain points. If the bullish trade appears to reach a steady level before stopping and reversing/reversing, it is said to have encountered resistance. If the bearish trade appears to bottom out at a certain price level before rising steadily, it is said to have encountered support. Traders look for price to break through identified support/resistance levels as a sign of new developing trends and a chance for quick profits. A lot of trading strategies rely on support/resistance lines.
Pivot Calculation
There are several derived formulas that help in evaluating support and resistance pivot points between currencies in a currency pair. These values can be tracked over time to judge the likelihood of prices breaking through certain levels. The calculation starts with the prices of the day before:
Pivot Point for Current = High (previous) + Low (previous) + Close (previous)
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The pivot point can then be used to calculate the estimated support and resistance for the current trading day.
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)
To fully understand how pivot points work, compile statistics for EUR/USD on the distance between each high and low of each calculated resistance (R1, R2, R3) and support level (S1, S2, S3).
To do the calculation yourself:
- Calculate pivot points, support levels and resistance levels for x number of days.
- Subtract the pivot points of support from the actual low of the day (Low – S1, Low – S2, Low – S3).
- Subtract the pivot points of resistance from the actual high of the day (High – R1, High – R2, High – R3).
- Calculate the mean of each difference.
The results since the creation of the euro (January 1, 1999, with the first trading day on January 4, 1999):
- The actual low is, on average, 1 pip below support 1.
- The actual high is, on average, 1 pip below Resistance 1.
- The actual low is, on average, 53 pips above support 2.
- The actual high is, on average, 53 pips below resistance 2.
- The actual low is, on average, 158 pips above support 3.
- The actual high is, on average, 159 pips below Resistance 3.
Judging the probabilities
Statistics indicate that the calculated pivot points of S1 and R1 are a decent gauge for the actual high and low of the trading day.
Going a step further, we calculated the number of days the low was lower at each S1, S2 and S3 and the number of days the high was higher at each R1, R2 and R3.
Result: there have been 2,026 trading days since the creation of the euro on October 12, 2006.
- The actual low was below S1 892 times, or 44% of the time.
- The actual maximum was greater than R1 853 times, or 42% of the time.
- The actual low has been below S2 342 times, or 17% of the time.
- The actual maximum was greater than R2 354 times, or 17% of the time.
- The actual low was below S3 63 times, or 3% of the time.
- The actual maximum was greater than R3 52 times, or 3% of the time.
This information is useful to a trader; If you know the pair is slipping below S1 44% of the time, you can place a stop below S1 with confidence, understanding that the odds are on your side. Also, you might want to take profits just below R1 because you know that the high of the day only goes above R1 42% of the time. Again, the odds are with you.
It is important to understand, however, that these are probabilities and not certainties. On average, the high is 1 pip below R1 and above R1 42% of the time. This does not mean that the high will exceed R1 four days out of the next 10, nor that the high will always be 1 pip below R1.
The power of this information is that you can confidently assess potential support and resistance ahead of time, have reference points to place stops and limits, and most importantly, limit risk while putting yourself in a position to profit.
Application of information
The pivot point and its derivatives are potential support and resistance. The examples below show a setup using a pivot point in conjunction with the popular RSI oscillator.
(For more information, see Momentum and Relative Strength Index)
RSI Divergence at Pivot Resistance/Support
This is usually a high reward/risk trade. The risk is well defined due to the recent high (or low for a buy).
Image by Sabrina Jiang © Investopedia 2021
The pivot points in the examples above are calculated using weekly data. The example above shows that from August 16-17, R1 held as strong resistance (first circle) at 1.2854 and the RSI divergence suggested that the upside was limited. This suggests that there is an opportunity to go short on a break below R1 with a stop at the recent high and a limit at the pivot point, which is now the support level:
- Sell short at 1.2853.
- Stop at the recent high at 1.2885.
- Bound at pivot point at 1.2784.
This first trade brought a profit of 69 pips with 32 pips of risk. The reward/risk ratio was 2.16.
The following week produced almost exactly the same setup. The week started with a rally towards and just above R1 at 1.2908, which was also accompanied by a bearish divergence. The short signal is generated when falling below R1, in which case we can sell short with a stop at the recent high and a limit at the pivot point (which is now support):
- Sell short at 1.2907.
- Stop at the recent high at 1.2939.
- Bound at pivot point at 1.2802.
This trade brought a profit of 105 pips with only 32 pips of risk. The reward/risk ratio was 3.28.
Setup rules
For traders who are bearish and short the market, the approach to setting pivot points is different from that of the bullish long trader.
For the shorts
1. Identify the bearish divergence at the pivot point, either R1, R2 or R3 (most common at R1).
2. When the price drops back below the reference point (it could be the pivot point, R1, R2, R3), initiate a short position with a stop at the recent high.
3. Place a limit order (take profit) at the next level. If you sold at R2, your first target would be R1. In this case, the former resistance becomes support and vice versa.
For a long time
1. Identify the bullish divergence at the pivot point, either S1, S2 or S3 (most common at S1).
2. When the price rises above the reference point (it could be the pivot point, S1, S2, S3), initiate a long position with a stop at the recent low.
3. Place a limit order (take profit) at the next level (if you bought in S2, your first target would be S1…former support becomes resistance and vice versa).
The essential
Pivot points are changes in the direction of market trade which, when plotted in succession, can be used to identify general price trends. They use the previous period’s high, low, and closing numbers to gauge support or resistance levels in the near future. Pivot points may be the most commonly used leading indicators in technical analysis. There are many types of pivot points, each with their own formulas and derivatives, but their underlying trading philosophies are the same.
When combined with other technical tools, pivot points can also indicate when there is a large and sudden influx of traders entering the market simultaneously. These market entries often result in breakouts and profit opportunities for range traders. Pivot points allow them to guess which important price points should be used to enter, exit or place stop losses.
Pivot points can be calculated for any time frame. A day trader can use daily data to calculate pivot points each day, a swing trader can use weekly data to calculate pivot points for each week, and a position trader can use monthly data to calculate pivot points at the start of each month.
Investors can even use annual data to approximate meaningful levels for the year ahead. The analysis and trading philosophy remains the same whatever the period. In other words, the calculated pivot points give the trader an idea of where the support and resistance are for the period ahead, but the trader should always be ready to act – because nothing in trading is more important. than preparation.
