If you’re exploring technical analysis, you might have heard of something called pivot points. But what are pivot points – and can they really help your trading? That’s what we’ll explore in this article.
A brief history
Pivot points were invented when professional traders used to operate on physical exchange floors.
In those days, if you wanted to trade an asset, you had to do it in person with other market participants. These trading floors often appear in popular culture. They were frantic settings, as market participants watched price movements.
Back then, there were no computers to calculate the difference in price movements. In fact, technical analysis was conducted manually with a pen and piece of paper.
It’s during this process that traders developed pivot points. Essentially, the indicate the aggregate direction of the market. They work across a variety of financial instruments – including currency pairs.
Calculating pivot points
So we now know that pivot points help traders determine the current direction of the market. This is useful because you can check whether your understanding of the fundamentals and market sentiment is accurate.
But how does a trader calculate pivot points? Well, it’s actually quite simple.
The trader just needs to note down some key price levels from the previous trading session. These include the highest and lowest prices of the session – and the market close price.
By adding together these three price levels – and dividing the result by three (the number of prices used in the calculation) – a trader can calculate a pivot point price.
- Highest Price + Lowest Price + Market Close Price
- Divide the total by three
It’s an important price point, because it’s essentially a price average of the last trading session. If current price is above the previous pivot point, the sentiment of the market is bullish. Conversely, price below the previous pivot point represents a bearish sentiment.
Most traders now use pivot points. Therefore, these levels are more significant in the market’s cumulative psychology. In other words, pivot points are significant price levels for the market.
Over time, traders also started calculating related levels from the original pivot point. Traders call these pivot support and resistance levels. Used correctly, they give traders more reference points to trade from each day.
Calculate the first levels of support and resistance as follows:
- R1 – First resistance = (2 x Pivot Point) – Low
- S1 – First support = (2 x Pivot Point) – High
Calculate the second levels of support and resistance as follows:
- R2 – Second resistance = Pivot Point + (S1 – R1)
- S2 – Second support = Pivot Point – (S1 – R1)
Finally, calculate the third levels of support and resistance in the following way:
- R3 – Third resistance = S1 + 2(Pivot Point – R1)
- S3 – Third support = R1 – 2(S1 – Pivot Point)
Again, these price points are key price levels for the market as a whole. They’re especially useful for short-term trading. When price reaches these levels, you should anticipate a market reaction – unless the fundamentals give a clear reason not to do so.
Utilising pivot points
Pivot points provide specific price levels that traders look to buy or sell from.
In this regard, they are support and resistance levels, just like Fibonacci retracement levels and price-based levels.
They also have another interesting application. They produce areas known as ‘zones’.
There are two zones you need to be aware of. Firstly, we have the buying zone – which is the area below your original pivot point. Conversely, the selling zone is the area above your original pivot point.
As previously mentioned, these zones represent bullish and bearish sentiments respectively. The deeper the current price is in within these the zones, the more likely it is that traders will attempt to trade the trend.
You can find your pivot support and resistance levels in each zone.
Support levels – which are found in the buying zone – will provide you with prices from which to buy from. Resistance levels – which are found in the selling zone – will provide you with prices from which to sell from.
What are pivot points?
The combination of zones and levels can provide you with a very clear technical analysis template.
With this, you can manage your entries, stop losses and profit targets. Remember, you should only do this after conducting fundamental analysis to identify sound trading opportunities.
However, you should apply caution to pivot points. Like other technical analysis strategies, it’s easy to become overly dependent on them. Instead, use pivot points to manage your trade – not to identify trading opportunities.
I hope this article is useful. If you have any questions, please leave them in the comments below.