It is useful for traders to have a map to be able to see current price relative to previous market action. The sentiment of traders and investors at any given moment can be seen. It also gives a general idea of where the market is heading during the day. Pivot Points were created for this purpose and the information they provide can help a trader decide which way to trade.
Pivot points, a technique developed by floor traders, help us see where the price is relative to previous market action.
What is a Pivot Point?
As a definition, a pivot point is a turning point or condition. This same definition applies to Pivot Points in a Forex market. The Pivot Point is a level in which the sentiment of the market changes from “bull” to “bear” or vice versa. The sentiment is bullish if the market breaks this level in an upwards direction and it is likely to continue its way up. On the other hand, the sentiment is bearish if the market breaks this level in a downwards direction and it is expected to continue its way down. Also at this level, the market is expected to have some kind of support/resistance. If the price can’t break the pivot point, a possible bounce from it is plausible.
Pivot points work best on highly liquid markets, like the spot currency market, but they can be a useful trading strategy for other markets as well.
Why do Pivot Points work?
They work simply because many individual traders and investors use and trust them, as well as bank and institutional traders. A majority of traders consider that the pivot point is an important measure of strength and weakness of a market.
Trading FOREX, and any other market, is as much about understanding the psychology of traders as it is about the understanding market trends and indicators. Many market strategies work for no other reason than the fact that traders believe in them. Whether you believe the concept or not, Pivot Points are heavily used by traders. This makes the resistance and breakouts that occur a trader driven self-fulfilling prophesy.
Calculating pivot points
There are several ways to arrive to the Pivot point. The method with the most accurate results is calculated by taking the average of the high, low and close of a previous period (or session).
Pivot point (PP) = (High + Low + Close) / 3
Take for instance the following EUR/USD information from the previous session:
The PP would be,
PP = (1.2474 + 1.2376 + 1.2458) / 3 = 1.2439
What does this number tell us?
It simply tells us that if the market is trading above 1.2439, Bulls are winning the battle pushing the prices higher. And if the market is trading below this 1.2439 the bears are winning the battle pulling prices lower. On both cases this condition is likely to sustain until the next session.
Since the Forex market is a 24hr market (no close or open from day to day) there is a eternal battle on deciding at white time we should take the open, close, high and low from each session. the times that produce the most accurate predictions are taking the open at 00:00 GMT and the close at 23:59 GMT.
There are other support and resistance levels that are calculated taking the Pivot Point as a reference, besides the calculation of the actual Pivot Point.
Support 1 (S1) = (PP * 2) – H
Resistance 1 (R1) = (PP * 2) – L
Support 2 (S2) = PP – (R1 – S1)
Resistance 2 (R2) = PP + (R1 – S1)
Where , H is the High of the previous period and L is the low of the previous period
Continuing with the example above, PP = 1.2439
S1 = (1.2439 * 2) – 1.2474 = 1.2404
R1 = (1.2439 * 2) – 1.2376 = 1.2502
R2 = 1.2439 + (1.2636 – 1.2537) = 1.2537
S2 = 1.2439 – (1.2636 – 1.2537) = 1.2537
These levels are generally accepted as marking support and resistance levels for the current session.
On the example above, the Pivot Point was calculated using information of the previous session (previous day.) This way we could see possible intraday resistance and support levels. It can also be calculated using the previous weekly or monthly data to determine such levels. Sentiment over longer periods of time is identified this way. Possible levels that might offer support and resistance throughout the week or month can also be seen. Calculating the Pivot Point in a weekly or monthly basis is mostly used by long term traders, however it can also be used by short time traders to provide an indication of the longer term trend.
S1, S2, R1 AND R2…? An Objective Alternative
As already stated, the Pivot Point zone is a well-known technique and it works simply because many traders and investors use and trust it. But what about the other support and resistance zones (S1, S2, R1 and R2,)? To forecast a support or resistance level with some mathematical formula is somewhat subjective. It is hard to rely on them blindly just because the formula came out at that level. For this reason, an alternative way to map the time frame has been created. A simpler but more objective and effective method.
The Pivot Point is calculated as shown before, but the support and resistance levels are drawn in a different way. Take the previous session high and low, and draw those levels on this session’s chart. The same is done with the session before the previous session. This will show the Pivot Points and four more important levels drawn in the chart.
LOPS1, low of the previous session.
HOPS1, high of the previous session.
LOPS2, low of the session before the previous session.
HOPS2, high of the session before the previous session.
PP, pivot point.
These levels will tell us the strength of the market at any given moment. If the market is trading above the Pivot Point, then the market is considered in a possible uptrend. When trading above HOPS1 or HOPS2, then the market is in an uptrend, and we only take long positions. If the market is trading below the Pivot Point then the market is considered in a possible downtrend. When trading below LOPS1 or LOPS2, then the market is in a downtrend, and we should only consider short trades.
The psychology behind this approach is simple. We know that for some reason the market stopped there from going higher/lower the previous session, or the session before that. The reason the market stopped isn’t know, but we do not need to know it. We only know the fact: the market reversed at that level. We also know that traders and investors remember, they remember where the price stopped before, and the odds are that the market reverses from there again. Even if it does not reverse the market will at least find some support or resistance at these levels.
What is important about this approach is that support and resistance levels are measured objectively, not just a level derived from a mathematical formula. In this approach it is known that the price reversed there before so these levels have a higher probability of being effective.
Our mapping method works on both market conditions, when trending and on sideways conditions. In a trending market, it helps us determine the strength of the trend and trade off important levels. On sideways markets it shows us possible reversal levels.
How to use this mapping method?
The mapping method can be used in three different ways:
- as a trend identification (measure of the strength of the trend)
- a trading system using important levels with price behaviour as a trading signal
- to set the risk reward ratio (RR) of any given trade based on where the is the market relative to the previous session.