Pivot Point Trading
We often hear market analysts or experienced traders talking about an equity price nearing a certain support or resistance level, each of which is important because it represents a point at which a major price movement is expected to occur. But how do these analysts and professional traders come up with these so-called levels? One of the most common methods is using pivot points.
First Some History Using pivot points as a trading strategy has been around for a long time and was originally used by floor traders. This was a nice simple way for floor traders to have some idea of where the market was heading during the course of the day with only a few simple calculations. Pivot points are yet another useful tool that can be added to any trader's toolbox. It enables anyone to quickly calculate levels that are likely to cause price movement. |
The reason pivot point trading is so popular is that pivot points are predictive as opposed to lagging. You use historical information of the previous day to calculate potential turning points for the day you are about to trade (present day).
Because so many traders follow pivot points you will often find that the market reacts at these levels. This will give give us an opportunity to place our trade.
How to Calculate Pivot Points
There are several different methods for calculating pivot points, the most common of which is the five-point system. This system uses the previous day's high, low and close, along with two support levels and two resistance levels (totaling five price points) to derive a pivot point. The equations are as follows:
Resistance 2 = Pivot + (R1
- S1)
Resistance 1 = 2 * Pivot - Low
Pivot Point = ( High + Close + Low )/3
Support 1 = 2 * Pivot - High
Support 2 = Pivot - (R1 - S1)
(You can plot the formulas above onto an excel sheet)
As you can see from the above formula, just by having the previous days high, low and close you eventually finish up with 5points, 2resistance levels, 2support levels and the actual pivot point.
If the market opens above the pivot point then the bias for the day is for long trades as long as price remains above the pivot point.
On 13 December 06 the daily
chart of Microsoft Stock as shown below had the following:
High - 29.59
Low - 29.32
Close - 29.53
This gave us:
Resistance 2 = 29.75
Resistance 1 = 29.64
Pivot Point = 29.48
Support 1 = 29.37
Support 2 = 29.21
The three most important pivot points are R1, S1 and the actual pivot point. The general idea behind trading pivot points is to look for a break of R1. By the time the market reaches R2 the market will already be overbought and these levels should be used for exits rather than entries. A perfect set up would be for the market to open above the pivot level and then stall slightly at R1 then go on to R2. You would enter on a break of R1 with a target of R2 and if the market was really strong close half at R2 |
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Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument.