Small Pivot Point Range Trading 33 ITM

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Using Pivot Points in Forex Trading

One tool that provides forex traders with potential support and resistance levels and helps to minimize risk is the pivot point and its derivatives. The use of reference points such as support and resistance, help determine when to enter the market, place stops, and take profits. However, many beginning traders divert too much attention to technical indicators including the moving average convergence divergence (MACD) and the 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 significantly improves the odds of success over the long haul.

In this article, we’ll argue 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 across a time interval, as though they were hinges from which trading swings either high or low. Originally employed by floor traders on equity and futures exchanges, they now are most commonly used in conjunction with support and resistance levels to confirm trends and minimize risk.

Similar to other forms of trend line analysis, pivot points focus on the important relationships between high, low and closing prices between trading days; that is, the previous day’s prices are used to calculate the pivot point for the current trading day. Even though they can be applied to nearly any trading instrument, pivot points have proved exceptionally useful in the forex (FX) market, especially when trading currency pairs.

Forex markets are very liquid and trade with very high volume attributes that reduce the impact of market manipulation that might 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, the support and resistance levels themselves rely on more subjective placements to help spot possible breakout trading opportunities.

Support and resistance lines are a theoretical construct used to explain the seeming unwillingness of traders to push the price of an asset beyond certain points. If bull trading appears to rise to a consistent level prior to stopping and retracing/reversing, it is said to have met resistance. If bear trading appears to hit a floor at a certain price point before consistently trading up again, it is said to have met support. Traders look for prices to break through identified support/resistance levels as a sign of new trends developing and a chance for quick profits. A great number of trading strategies rely on support/resistance lines.

Calculating Pivots

There are several derivative formulas that help evaluate support and resistance pivot points between currencies in a forex pair. These values can be tracked over time to judge the probability of prices moving past certain levels. The calculation begins with the previous day’s prices:

Pivot Point for Current = High (previous) + Low (previous) + Close (previous)
3

The pivot point can then be used to calculate estimated support and resistance for the current trading day.

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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 get a full understanding of how well pivot points can work, compile statistics for the EUR/USD on how distant each high and low has been from each calculated resistance (R1, R2, R3) and support level (S1, S2, S3).

To do the calculation yourself:

  • Calculate the pivot points, support levels and resistance levels for x number of days.
  • Subtract the support pivot points from the actual low of the day (Low – S1, Low – S2, Low – S3).
  • Subtract the resistance pivot points from the actual high of the day (High – R1, High – R2, High – R3).
  • Calculate the average for each difference.

The results since the inception 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 Probabilities

The 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 farther, we calculated the number of days that the low was lower than each S1, S2, and S3 and the number of days that the high was higher than each R1, R2, and R3.

The result: there have been 2,026 trading days since the inception of the euro as of October 12, 2006.

  • The actual low has been lower than S1 892 times, or 44% of the time.
  • The actual high has been higher than R1 853 times, or 42% of the time.
  • The actual low has been lower than S2 342 times, or 17% of the time.
  • The actual high has been higher than R2 354 times, or 17% of the time.
  • The actual low has been lower than S3 63 times, or 3% of the time.
  • The actual high has been higher than R3 52 times, or 3% of the time.

This information is useful to a trader; if you know that the pair slips below S1 44% of the time, you can place a stop below S1 with confidence, understanding that probability is on your side. Additionally, you may want to take profits just below R1 because you know that the high for the day exceeds R1 only 42% of the time. Again, the probabilities 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 exceeds R1 42% of the time. This neither means that the high will exceed R1 four days out of the next 10, nor that the high is always going to be 1 pip below R1.

The power in this information lies in the fact that you can confidently gauge 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.

Applying the 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.

RSI Divergence at Pivot Resistance/Support

This is typically a high reward-to-risk trade. The risk is well-defined due to the recent high (or low for a buy).

The pivot points in the above examples are calculated using weekly data. The above example shows that from August 16 to 17, R1 held as solid 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.
  • Limit at the pivot point at 1.2784.

This first trade netted a 69 pip profit with 32 pips of risk. The reward to risk ratio was 2.16.

The next week produced nearly the exact same setup. The week began with a rally to and just above R1 at 1.2908, which was also accompanied by bearish divergence. The short signal is generated on the decline back below R1 at which point 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.
  • Limit at the pivot point at 1.2802.

This trade netted a 105 pip profit with just 32 pips of risk. The reward to risk ratio was 3.28.

Rules for Setup

For traders who are bearish and shorting the market, the approach to setting pivot points is different than for the bullish, long trader.

For Shorts

1. Identify bearish divergence at the pivot point, either R1, R2 or R3 (most common at R1).
2. When the price declines back below the reference point (it could be the pivot point, R1, R2, R3), initiate a short position with a stop at the recent swing high.
3. Place a limit (take profit) order at the next level. If you sold at R2, your first target would be R1. In this case, former resistance becomes support and vice versa.

For Longs

1. Identify bullish divergence at the pivot point, either S1, S2 or S3 (most common at S1).
2. When price rallies back above the reference point (it could be the pivot point, S1, S2, S3), initiate a long position with a stop at the recent swing low.
3. Place a limit (take profit) order at the next level (if you bought at S2, your first target would be S1 … former support becomes resistance and vice versa).

The Bottom Line

Pivot points are changes in market trading direction that, when charted in succession, can be used to identify overall price trends. They use the prior time period’s high, low and closing numbers to assess levels of support or resistance in the near future. Pivot points may be the most commonly used leading indicators in technical analysis. There are many different types of pivot points, each with their own formulas and derivative formulas, but their implied 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 inflows often lead to breakouts and opportunities for profits for range-bound forex 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 the pivot points each day, a swing trader can use weekly data to calculate the pivot points for each week and a position trader can use monthly data to calculate the pivot points at the beginning of each month.

Investors can even use yearly data to approximate significant levels for the coming year. The analysis and trading philosophy remains the same regardless of the time frame. That is, the calculated pivot points give the trader an idea of where support and resistance are for the coming period, but the trader must always be prepared to act – because nothing in trading is more important than preparedness.

Pivot Strategies for Forex Traders

For many years, traders and market makers have used pivot points to determine critical support and/or resistance levels. Pivots are also very popular in the forex market and can be an extremely useful tool for range-bound traders to identify points of entry and for trend traders and breakout traders to spot the key levels that need to be broken for a move to qualify as a breakout.

In this article, we’ll explain how pivot points are calculated, how they can be applied to the FX market, and how they can be combined with other indicators to develop other trading strategies.

Calculating Pivot Points

By definition, a pivot point is a point of rotation. The prices used to calculate the pivot point are the previous period’s high, low and closing prices for a security. These prices are usually taken from a stock’s daily charts, but the pivot point can also be calculated using information from hourly charts. Most traders prefer to take the pivots, as well as the support and resistance levels, off of the daily charts and then apply those to the intraday charts (i.e., hourly, every 30 minutes or every 15 minutes). If a pivot point is calculated using price information from a shorter timeframe, this tends to reduce its accuracy and significance.

The textbook calculation for a pivot point is as follows:

Central Pivot Point (P) = (High + Low + Close) / 3

Support and resistance levels are then calculated off of this pivot point, which are outlined in the formulas below.

  • First level support and resistance:

First Resistance (R1) = (2*P) – Low

First Support (S1) = (2*P) – High

  • The second level of support and resistance is calculated as follows:

Second Resistance (R2) = P + (R1-S1)

Second Support (S2) = P – (R1- S1)

Calculating two support and resistance levels is common practice, but it’s not unusual to derive a third support and resistance level as well. (Note: third-level support and resistances are a bit too esoteric to be useful for the purposes of trading strategies.) It’s also possible to delve deeper into pivot point analysis; for example, some traders go beyond the traditional support and resistance levels and also track the mid-point between each of those levels.

Applying Pivot Points to the FX Market

Generally speaking, the pivot point is seen as the primary support or resistance level. The following chart is a 30-minute chart of the currency pair GBP/USD with pivot levels calculated using the daily high, low and close prices.

Figure 1. This chart shows a common day in the FX market. The price of a major currency pair (GBP/USD) tends to fluctuate between the support and resistance levels identified by the pivot point calculation. The areas circled in the chart are good illustrations of the importance of a break above these levels.

The Significance of FX Market Opens in Pivot Points

There are three market opens in the FX market: the U.S. open, which occurs at approximately 8 a.m. EDT, the European open, which occurs at 2 A.M. EDT, and the Asian open which occurs at 7 P.M. EDT.

What we also see when trading pivots in the FX market is that the trading range for the session usually occurs between the pivot point and the first support and resistance levels because a multitude of traders play this range. In Figure 2 (below), a chart of the currency pair USD/JPY, you can see in the areas circled that prices initially stayed within the pivot point and the first resistance level with the pivot acting as support. Once the pivot was broken, prices moved lower and stayed predominately within the pivot and the first support zone.

Figure 2. This chart shows an example of the strength of the support and resistance calculated using the pivot calculations

One of the key points to understand when trading pivot points in the FX market is that breaks tend to occur around one of the market opens. The reason for this is the immediate influx of traders entering the market at the same time. These traders go into the office, take a look at how prices traded overnight and what data was released and then adjust their portfolios accordingly. During the quieter time periods, such as between the U.S. close (4 P.M. EDT) and the Asian open (7 P.M. EDT) (and sometimes even throughout the Asian session, which is the quietest trading session), prices may remain confined for hours between the pivot level and either the support or resistance level. This provides the perfect environment for range-bound traders.

Two Strategies Using Pivot Points

Many strategies can be developed using the pivot level as a base, but the accuracy of using pivot lines increases when Japanese candlestick formations can also be identified. For example, if prices traded below the central pivot (P) for most of the session and then rose above the pivot while simultaneously creating a reversal formation (such as a shooting star, Doji or hanging man), you could sell short in anticipation of the price resuming trading back below the pivot point.

A perfect example of this is shown in Figure 3 (below), a 30-minute USD/CHF chart. USD/CHF had remained range-bound between the first support zone and the pivot level for most of the Asian trading session. When Europe joined the market, traders began taking USD/CHF higher to break above the central pivot. Bulls lost control as the second candle became a Doji formation.

Prices then began to reverse back below the central pivot to spend the next six hours between the central pivot and the first support zone. Traders watching for this formation could have sold USD/CHF in the candle right after the doji formation to take advantage of at least 80 pips worth of profit between the pivot point and the first level of support.

Figure 3. This chart shows a pivot point being used in cooperation with a candlestick pattern to predict a trend reversal. Notice how the descent was stopped by the second support level.

Another strategy employed by traders is to look for prices to obey the pivot level, therefore validating the level as a solid support or resistance zone. In this type of strategy, you’re looking for the price to break the pivot level, reverse and then trend back towards the pivot level. If the price proceeds to drive through the pivot point, this is an indication that the pivot level is not very strong and is, therefore, less useful as a trading signal. However, if prices hesitate around that level or “validate” it, then the pivot level is more significant and suggests that the move lower is an actual break, which indicates that there may be a continuation move.

The 15-minute GBP/CHF chart in Figure 4 (below) shows an example of prices “obeying” the pivot line. For the most part, prices were first confined within the mid-point and pivot level. At the European open (2 A.M. EDT), GBP/CHF rallied and broke above the pivot level. Prices then retraced back to pivot level, held it and proceeded to rally once again. The level was tested once more right before the U.S. market open (7 A.M. EDT), at which point traders should have placed a buy order for GBP/CHF since the pivot level had already proved to be a significant support level. For those traders who employed that strategy, GBP/CHF bounced off the level and rallied once again.

Figure 4. This is an example of a currency pair “obeying” the support and resistance identified by the pivot point calculation. These levels become more significant the more times the pair tries to break through.

The Bottom Line

Traders and market makers have been using pivot points for years to determine critical support and/or resistance levels. As the charts above have shown, pivots can be especially popular in the FX market since many currency pairs do tend to fluctuate between these levels. Range-bound traders will enter a buy order near identified levels of support and a sell order when the asset nears the upper resistance. Pivot points also enable trend and breakout traders to spot key levels that need to be broken for a move to qualify as a breakout. Furthermore, these technical indicators can be very useful when the market opens.

An excellent way for individual investors to become more attuned to market movements and make more educated transaction decisions comes from having an awareness of where these potential turning points are located. Given their ease of calculation, pivot points can also be incorporated into many trading strategies. The flexibility and relative simplicity of pivot points definitely make them a useful addition to your trading toolbox.

How to Calculate Pivot Points

The first thing you’re going to learn is how to calculate pivot point levels.

The pivot point and associated support and resistance levels are calculated by using the last trading session’s open, high, low, and close.

Pivot Point Calculation

The calculation for a pivot point is shown below:

Pivot point (PP) = (High + Low + Close) / 3

Support and resistance levels are then calculated off the pivot point like so:

First level support and resistance:

First resistance (R1) = (2 x PP) – Low

First support (S1) = (2 x PP) – High

Second level of support and resistance:

Second resistance (R2) = PP + (High – Low)

Second support (S2) = PP – (High – Low)

Third level of support and resistance:

Third resistance (R3) = High + 2(PP – Low)

Third support (S3) = Low – 2(High – PP)

Keep in mind that some forex charting software plot intermediate levels or mid-point levels.

If you hated algebra, have no fear because you don’t have to perform these calculations yourself.

We here at BabyPips.com also have our very own Pivot Point Calculator!

The forex pivot point calculator can come in handy, especially if you want to do a little back testing to see how pivot point levels have held up in the past.

Remember, one of the advantages of using pivot points is that it is objective, so it’s very easy to test how price reacted to them.

Next up, we’ll teach you the various ways in which you can incorporate pivot points into your forex trading strategy.

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