The pivot point is one of the most widely used indicators in day trading. This tool provides a specific plot of seven support and resistance levels aimed at finding intraday change points in the market.
Below is a look at how they appear on the hourly chart of the AUD/JPY currency pair. All seven levels are on display.
Although traders often find their own support and resistance levels by looking for previous change points in the market, pivot points plot automatically every day. Since many market participants detect these levels, the price tends to respond to them.
Pivot Point Calculation
Pivot points can be calculated for various time periods in some charting software programs that allow you to customize the indicator. For example, some programs may allow you to calculate pivot points for weekly or monthly intervals. But the standard indicator is plotted at the daily level.
Central price levels – pivot points – are calculated as a function of the market’s high, low, and close from the previous day (or period, more generally). These values are summed and divided by three. This is the same concept as “typical price”.
Pivot Point = [High (previous) + Low (previous) + Close (previous)] / 3
The other six price levels – three support levels and three resistance levels – all use pivot point values as part of their calculations.
The three simple support levels are called support 1, support 2, and support 3. The three resistance levels are called resistance 1, resistance 2, and resistance 3. You can also see them called by their trick form – S1, S2, S3, and R1, R2, R3.
These values are calculated as follows:
- 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 – (Match 1 – Support 1)
- Resistance 3 = (Pivot Point – Support 2) + Resistance 2
- Support 3 = Pivot Point – (Resistance 2 – Support 2)
Since price levels are based on the previous day’s high, low, and close, the wider the range between these values the greater the distance between the levels on the following trading day. Likewise, the smaller the trading range, the lower the distance between levels will be the next day.
It should be noted that not all levels will necessarily appear on the chart at once. This means that the price chart scales in such a way that some levels are not included in the viewing window.
Uses of Pivot Points
Pivot points were initially used on stocks and in the futures market, although the indicator has been widely adapted to the day trading of the forex market.
Pivot points have the advantage of being leading indicators, which means traders can use the indicator to gauge potential turning points in the market ahead of time. They can act as trade entry targets themselves by using them as support or resistance, or as levels to stop losses and/or take profits.
For example, below, we can see some cases of S1 acting as a support.
The pivot point, that is the middle line and the level from which everything counts, is the main focus. If the price is trading above the pivot point, the market sentiment may be considered bullish for the day (although it is still possible that the market is down for the day if this is true).
If the market is flat, the price may drop and flow around the pivot point. We can see the type of price behavior in the chart below.
Although R1, R2, and R3 are mentioned in the sense that they are likely to act as resistance when the market is rising, if the price runs above them, they can also act as support if the price is going down. The same goes for S1, S2, and S3, which can act as counter to any moves that arise when they break as support.
For example, here we see a resistance level acting as support
Using Pivot Points for Gauging Probabilities
Pivot points are also used by some traders to estimate the probability of a price move that is self-sustaining. Although it depends on the market, the following probabilities are usually reported in terms of how likely the price is to close the trading day above or below the following levels:
- Closes higher than R1 40% of the time
- Closes lower than S1 40% of the time
- Closes higher than R2 15% of the time
- Closes lower than S2 15% of the time
- Closes higher than R3 5% at that time
- Closes lower than Q3 5% of the time
This, of course, is a rough estimate. Just because the price moves above or below the outlier doesn’t necessarily mean the move is invalid or unsustainable. For example, never assume that, based on the information above, you have an 85% chance of winning the trade if you take a long position when the price hits S2. That certainly won’t happen by itself.
Pivot Points as Stop Losses
Some traders will take a trade at a level, expecting a reversal at the touch, while using the next level below it (in the case of a long trade) or above it (in the case of a short trade) as a stop-loss.
Trading Using Pivot Points
At this point, it should seem pretty clear that pivot points are used as point prospects in the market. Taking a trade at this level in the direction of an expected reversal is a very common technical strategy.
To increase the viability of this strategy, traders will tie the pivot point strategy to other indicators. For example, one might use a simple 50-step moving average to gauge a trend and bias one trade only in the direction of that trend.
Furthermore, instead of taking a first touch on a pivot level, one may need a secondary touch to confirm that the level is valid as a turning point. Here is an example of why it is better to “verify” the validity of a level before trading on a fundamental touch. This is a five minute chart of EUR/USD.
When data or news comes out, the volume increases significantly and previous trade moves and daily support and resistance levels quickly become obsolete. On the large green bar, the price is indeed holding between the two pivot levels. But if we trade every pivot touch, we will make long and short trades in five minutes.
After that, the market weakened and fell steadily, showing no sensitivity to pivot points.
Therefore, you need to be careful and make sure that you do not try to trade a level that the market has no intention of respecting when large amounts are present in the market.
If we write our rules for this system:
1. a) If the 50-step simple moving average is positive, take a long trade only.
b) If the 50-step simple moving average is negative, take a short trade only.
2. Take trades on the secondary contact of the pivot level after confirming that the primary contact is a rejection of the level.
This will be used on the 5 minute chart, but can also be used to compress higher (or lower) time frames.
For day traders, who use daily pivot points, using a 5-minute to hourly chart is the most reasonable. Swing traders may be better off using weekly pivot points to apply the strategy on the four-hour chart for each day. Positioning traders are probably best suited to use monthly pivot points on either a daily or weekly chart.
But this is a relatively simple system that can be effective.
Example
Here we have a 5-minute chart of the EUR / USD currency pair.
Price is in a downtrend for today, price bounces off the S2 level (acting as resistance) once after the shift, resulting in a short trade when the secondary touches the S2
This trade worked well, after resuming the downtrend shortly after.
Now, of course, the question is, how do you decide where to exit?
Before placing a trade, you need to have an exit plan. This can take many forms.
Some options are shown in the figure below.
The resistance level shortly after the trade started to move in our direction. Naturally, expecting resistance to form there again in the future can be reasonable.
Moreover, if the price starts to consolidate and any momentum in the trend – or volume in the market as a whole – has faded, then we can simply choose to exit the trade.
Or we can touch the moving average. Some traders use some of the more popular moving averages – 50-, 100-, and/or 200-period – as support and resistance levels or consider a trend change if the price is above where the moving average is being detected.
Natural profit gains in the pivot point system are also, of course, at the next level in the hierarchy. In this case, if we take a short trade at S2, our profit level might be S3. But as mentioned above, reaching the outermost levels, such as S3 and R3, is usually rare.
It is very defensible for day traders to take trades off the table towards the end of the trading day when volume drops sharply.
A Word on Time Zones
Also keep in mind that pivot points are sensitive to time zones. Pivot points are best seen based on closing prices in New York or London.
Therefore, someone using charting software using a closing time based in San Francisco or Tokyo or some other time zone may have different pivot points drawn on their chart that may not be followed on a large scale internationally. This has the potential to render them unmuted or worthless.
Therefore, it is recommended that your chart time is set to New York time or London time. How this relates to GMT or UTC specifically depends on where each is in the calendar, as both cities use daylight savings time.
Whichever time zone you choose, be aware that pivot points can be pulled back by going through previous price data. It is important to make sure that the price is sensitive to this level in the market you are trading.
The conclusion
Pivot points provide insight into future potential and resistance levels in the market. This can help traders as a key indicator to know where prices can change or combine. They can also be used as stop-loss or take profit.
Although daily pivot points are the most common and best suited for day traders, some charting platforms will allow you to plot them for other time frames as well (eg, weekly, monthly).
As with all indicators, they should not be used as the only thing you base your trades on. They should be used in addition to other forms of analysis and/or other technical indicators.