For the use of forex brokers and analysts, there are various types of technical analysis indicators that are used to understand the prevailing overall trend of the market. From the variety of indicators, one of the most subjective objective indicators available to forex traders and market makers are pivot points. These indicators do not involve any discretion and many traders keep an eye on the price level that it determines.
Pivot points are used to identify potential support and resistance levels, at which the direction of price might possibly change. The pivot point is calculated by taking an average of high, low, and closing price of the previous day.
The support and resistance, that are used to analyze the trend lines, are calculated by using the width of the trading range. This trading range lies between the pivot point and either of the high or low prices of the previous day.
These points are usually considered to be useful for short-term traders who are looking to take advantage of small price movements in the market.
These are the two common strategies used by forex traders to trade the bounce or break of these levels.
This strategy is used to identify reversal points with the help of pivot points. This is mostly used by rangebound traders who see areas of pivot points as places where they can buy or sell orders.
It is used by breakout forex traders to identify key levels that need to be broken in order for it to be classified as a real deal breakout.
Just like every other technical indicator and tools used in the forex or simply say the financial world has its own language, pivot points do seem to have their own set of acronyms that are commonly used when analyzing charts. These acronyms are mentioned below.
PP – Pivot Point
S – Support
R – Resistance
For you to have a clear understanding of how these acronyms are used and marked on the charts we’ve provided you with an example of these points plotted and marked on a 1-hour EUR/USD chart.
The most important thing you need to learn before trading with the help of this technical analysis indicator is calculating pivot point levels.
These levels are calculated using the averages of last trading day and have their own respective formulas. If on the next trading day, trading seems to take place above the pivot point then it indicates a bullish sentiment in the market. But if it trades below the pivot point then it indicates bearish sentiment in the market and its participants.
The formulas for calculating these points are as follows
Pivot Point (PP) = (High + Low + Close) / 3
Level I: Support and Resistance
S1 = (2 x PP) – High
R1 = (2 x PP) – Low
Level II: Support and Resistance
S2 = PP – (High – Low)
R2 = PP + (High – Low)
Level III: Support and Resistance
S3 = Low – 2 (High –PP)
R3 = High = 2 (PP – Low)
These points that are calculated and marked on the charts are static and remain at the same prices throughout the day. Each of these calculated levels is considered as a pivot point by forex traders, and sometimes even new levels known as mid-point levels or intermediate levels are included to expand the range.
However, you don’t need to particularly worry about its calculations as most of the trading software perform these calculations on their own and show the final results on the screen. One such example is as follows.
For Range Trading
It is always recommended to use the levels of pivot points just like regular levels of support and resistance. This is because it is very likely that the price will keep testing these levels time and again. Once the price touches a level, the stronger that level gets and it is predicted that a reversal is going to take place soon.
If the pivot level holds, which shows the strength of that level, it can provide some good trading opportunities for you. For example, if the price starts nearing a support level, which means it is dropping then you can place a buy order and put your stop just below the level if you are confident that the level would hold and reverse.
In the same way, if the price starts building up and nears the upper resistance levels then you can place a sell order for your pair and place a stop just above the resistance.
To understand this clearly, let’s take the help of a chart.
The chart clearly shows that price is testing the first support level. If you are positive that the price would hold then buy at the current market price and place a stop order just below the support level, but if you are not so confident then put a stop loss order past the next support level.
If it does cross the first support level and starts nearing the second then chances are the market won’t reverse and become new resistance levels.
For taking profits from these levels, when the market is nearing S1 and you believe would reverse, PP or R1 could be your target points where you buy at the market price and hope that it would start nearing the resistance levels.
The chart above shows that S1 did hold as support and the market reversed after it reaching for PP. If you had PP as you take profit point then this is time for celebration!
But you shouldn’t heavily rely on these points and make use of other techniques and charts that can help you give a more realistic estimate of the market.
To Trade Breakouts
Trading mostly takes place between the first resistance and support levels, sometimes tests the second levels and rarely tests the third levels. But what should one do if once in a blue moon it does break out these levels and starts nearing the next one? Well, that’s what we told you before that these points won’t hold forever just like normal support and resistance levels.
To trade these breakouts there are two common ways; the aggressive way where you place your stop just below S1 or the safe way where you set a wide stop just below S2. Both these ways are going to work fine, but do keep in mind that in playing safe you will have to wait for more for the next level to be tested because of which you might lose out on the initial level opportunities.
The chart clearly indicates EUR/USD making a strong rally throughout the day. It started off by taking a gap above the PP. Price strongly started to move up with a slight pause at R1. The pause broke and the pair jumped upwards by almost 50 pips. Here opting for the aggressive strategy would have allowed you to catch on to the opportunities on the initial level.
However, the currency pair bull makes a run for R3 as well and hits that too. One thing to notice here is that if you had taken the aggressive method here then you would have got caught in the fake out as the price started soaring up and not sustained at that initial level. The price also did break through the next level but notice how it was retested before breaking through.
Later, we can see how R3 played ‘role reversal’ by being resistance-turned-support-turned-resistance level. This is an opportunity for forex traders to place a short on the retest situation.
To Measure Market Sentiment
One way to use pivot points is to gauge the market sentiment. This means that what are market participants more inclined to; buying or selling. This can be determined by watching the price like a hawk. If the price breaks through above the pivot point then it is an indicator that the traders are bullish and you should buy at the current market price.
On the contrary, if the price breaks through below the pivot point and starts nearing the support level then you should start selling the pair as this downward movement is an indicator of bearish sentiment in the market.
Let’s look at an example to better understand what is happening.
This chart shows how the price tested PP which was serving as a resistance level and then started to decline. This movement of the price below the pivot point shows that there is a bearish sentiment in the market and it is recommended to sell at this point. And if you did sell then you are in for some good time as the currency pair did fall by 300 pips.
But, of course, this is not always the case. There are times when you might think that the market has a bearish sentiment about a currency pair only to see that it reverses and the bull breaks through the top crossing all resistance levels.
This is why you cannot completely base your trading decisions on the sole technique of pivot point analysis and should combine it with other tools and technical analysis indicators to help you determine overall market sentiment.
The standard pivot point calculation is the one we’ve discussed with you involving a PP and 3 support and resistance levels respectively. However, there are three other types with which you can calculate pivot points and its levels.
Fibonacci Pivot Point
Fibonacci pivot points are calculated as per their retracement and extension levels with help of Fibonacci ratios, but the pivot point is calculated by the standard formula.
PP = (High + Low + Close) / 3
R3 = PP + [(High – Low) x 1.000]
R2 = PP + [(High – Low) x 0.618]
R1 = PP + [(High – Low) x 0.382]
S1 = PP – [(High – Low) x 0.382]
S2 = PP – [(High – Low) x 0.618]
S3 = PP – [(High – Low) x 1.000]
The chart below indicates how Fibonacci levels (solid lines) differ from standard method (dotted lines)
Woodie Pivot Point
In this type, the calculations are much different from the standard method. Also, you need to take a range (previous day’s highs and lows) to calculate corresponding support and resistance levels.
The formulas are as follows.
R2 = PP + High – Low
R1 = (2 X PP) – Low
PP = (High + Low + 2Closing) / 4
S1 = (2 X PP) – High
S2 = PP – High + Low
Here below is an example of a chart that shows the difference between levels obtained through Woodie PP calculations (solid lines) and standard PP method (dotted lines).
There are some forex traders who prefer Woodie over standard method for pivot points calculation because it gives more weight age to closing prices of the previous day when calculating Pivot Point.
Camarilla Pivot Point
Calculation of pivot points through this formula is similar to Woodie as it also uses range (previous day’s highs and lows) to calculate corresponding support and resistance levels. The difference between these two is that you need to calculate 8 levels in total; 4 for resistance and 4 for support and multiply each of them with a multiplier.
The formulas are as follows.
PP = (High + Low + Closing) / 3
R4 = Closing + [(High – Low) x 1.5000]
R3 = Closing + [(High – Low) x 1.2500]
R2 = Closing + [(High – Low) x 1.1666]
R1 = Closing + [(High – Low) x 1.0833]
S1 = Closing – [(High – Low) x 1.0833]
S2 = Closing – [(High – Low) x 1.1666]
S3 = Closing – [(High – Low) x 1.2500]
S4 = Closing – [(High – Low) x 1.5000]
The concept behind these calculations is that the price will revert back to its mean position which is previous day’s close. So the idea, basically, that it wants to deliver is that you should buy or sell once the price nears the third support and resistance levels.
A graph below shows the difference between calculations of standard method (dotted lines) and camarilla’s method (solid lines).
From these three types, it is hard to point out which one of them is the best as compared to others, since they are all variations of each other. What really matters is how you combine all your knowledge of forex, its tools, and techniques and use it to devise a trading strategy that best suits your needs.