Pivot points enable traders to spot market turning points, but they can be complicated for beginners. Discover how they work in this detailed guide!
- How Pivot Points are Calculated
- How Pivot Points are Used
- Gauging Probabilities with Pivot Points
- Conducting Trades with Pivot Points
- Considering Time Zone Differences
- Conclusion
Pivot points are among the most popular indicators used by day traders, providing a plot of seven support and resistance levels. These are designed to locate intraday turning points within the market.
Generally, traders pinpoint their own support levels and resistance levels by finding prior market turning points, but pivot points automatically plot each day. As a lot of people involved in the market track these levels, price typically reacts to them.
How Pivot Points are Calculated
Pivot points may be calculated for a number of timeframes in certain charting software platforms which enable you to tailor the indicator to your own preferences. So, some might offer you the option to calculate pivot points at weekly or monthly intervals, though the standard indicator plots on a daily level.
The core price level (the pivot point itself) is worked out as a function of the prior day’s (or period’s) market high, low, and close. These values will be summed before being divided by three — the same in concept as the ‘typical price’:
Pivot Point = [High (previous) + Low (previous) + Close (previous)] / 3
The six additional price levels (three support, three resistance) utilize the pivot point value within their calculations. For convenience, the three support levels are referred to as support 1 (S1), support 2 (S2), and support 3 (S3).
Likewise, the three resistance levels are resistance 1 (R1), resistance 2 (R2), resistance three (R3).
These are worked out in the following way:
- 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)
As the price levels are based on the previous day’s high, low, and close, on the following trading day the range between these values, and the distance between levels, will correspond. The wider the values’ range, the larger that distance will be.
Similarly, the more concise the trading range, the lower the distance between levels will be on the subsequent trading day.
However, be aware that not all levels are guaranteed to feature on a chart together. This just means that the price chart’s scale is such that certain levels won’t be included in the viewing window.
How Pivot Points are Used
Originally, pivot points were leveraged for stocks and futures markets, but this indicator has since been adapted to suit day trading the forex market since.
Pivot points are a leading indicator, which means that traders can utilize them to measure possible market turning points before they occur. They may serve as trade entry targets by utilizing them as resistance or support, or as stop-loss levels and take-profit levels.
As the pivot point is the middle line and the level that everything else becomes calculated from on charts, it’s the main focus. When price trades above the pivot point, it’s likely that market sentiment for the day would be bullish — but a market could still be down for the day even if this is true.
Price could fluctuate around the pivot point if the market is flat. While resistance levels can be reasonably expected to serve as resistance while the market increases, they can also work as support if price runs above them, if the price was to drop.
It’s similar for the three support levels: they may act as resistance on a move back up when they break as support.
Gauging Probabilities with Pivot Points
Some traders use pivot points to estimate the probability of a price move being able to sustain itself. While this is dependent on the market, the probabilities covered below are typically reported in terms of how likely price is to close the trading day over or under these levels:
- Closes above R1 40% of the time
- Closes below S1 40% of the time
- Closes above R2 15% of the time
- Closes below S2 15% of the time
- Closes above R3 5% of the time
- Closes below S3 5% of the time
Remember, though, that these are just rough approximations — just because price moves over or under the outer levels doesn’t make the moves invalid or unsustainable. For instance, never use the information above to assume there’s an 85% chance to win a trade if you take a long position once price reaches S2. That won’t be true in itself.
Conducting Trades with Pivot Points
By now, it may appear somewhat obvious that pivot points are utilized as prospective market turning points. It’s a common technical tactic to take trades at these levels in the direction of the reversal anticipated.
To enhance this approach’s viability, traders will connect the pivot points strategy to alternative indicators: for example, using a 50 period simple moving average (SMA) to gauge the trend and bias your own trades in that trend’s direction only.
Furthermore, rather than taking the first touch of a pivot level, you may need a secondary touch to confirm the level’s validity as a turning point.
But be careful: market conditions can change quickly and start to show no sensitivity to pivot points.
You need to take care that you don’t attempt to trade levels the market doesn’t intend to respect when big volume is within the market.
If we decided to create our rules for this system, they would look like this:
- a) Take long trades if the 50 period SMA slopes positively
b) Take short trades if the 50 period SMA slopes negatively
- Take trades on a secondary touch of the pivot level once you affirm the primary touch is a rejection of the level first
While this would be applied to a five minute chart, it can also be applied to time compressions that are lower or higher.
Day traders using daily pivot points may find the five minute to hourly chart best. Swing traders using weekly pivot points might find it best to use the strategy on the four hour to daily chart.
Last but not least, position traders could likely benefit from using monthly pivot points on the daily or weekly chart.
Some traders utilize a number of the most popular moving averages (e.g. a 50 period) for support and resistance levels, or consider a change in the trend if price reaches above whatever moving average they’re tracking.
A natural take-profit in a pivot points system is at the hierarchy’s next level. So, if you were to take a short trade at S2, the take-profit level could be S3. But reaching the outermost levels (R3 and S3, for example) is pretty rare.
Day traders may like to take trades off the table as the trading day is approaching its close and volume declines.
Considering Time Zone Differences
Pivot points are sensitive to time zones, and the majority are viewed based off London or New York closing prices.
So, a trader utilizing charting software and a closing time that’s based in Tokyo or another time zone might have multiple pivot points plotted across their chart that aren’t followed elsewhere around the world. This could leave them muted or of no value.
It’s best to set your charting times to London or New York hours, but the way in which these relate to GMT or UTC specifically is affected by the calendar — both cities, of course, follow daylight savings time.
But regardless of your chosen time zone, be aware that pivot points may be backtested using previous price data. Make sure price is sensitive to these levels in the market you choose to trade.
Conclusion
Pivot points give you an insight into the market’s possible resistance and support levels in the future. These may be particularly beneficial as a leading indicator for traders, helping them to identify where price might turn or consolidate. These can also be utilized as stop-loss or take-profit levels.
Though daily pivot points are the most widely used and suitable for day traders, certain charting platforms enable you to plot them for different timeframes (such as monthly or weekly).
They shouldn’t be the sole thing you conduct your trades on, though, as with any indicator. It’s best to utilize them alongside alternative analysis methods and/or other technical indicators.
