Historically, pivot points are one of the most popular technical tools and indicators used by Forex traders, regardless of their level of experience in the markets. Essentially a price level which indicates the market’s direction (or sentiment), pivot points are indicators represented by a line on a price chart that divides support and resistance.
What are Pivot Point?
Put simply, pivot points (PP) are benchmarks that traders use to get a feel for the way the market is moving; whether the financial instrument they’re trading has a bullish or a bearish inclination. A bearish sentiment is formed when the price goes below the PP level, and in contrast, the bulls are in play if the price goes beyond the PP level.
To calculate PP, a mean average of the high, low and close prices is taken from the last completed candlestick formation. Here’s what the formula looks like:
Pivot Point (PP) = (Previous High + Previous Low + Previous Close) / 3
Once the PP is found, resistance (R1, R2 and R3) and support (S1, S2 and S3) levels are calculated as follows:
R3 = High + 2*(PP – Low)
R2 = PP + High – Low
R1 = 2*PP – Low
S1 = 2*PP – High
S2 = PP – (High – Low)
S3 = Low – 2*(High-PP)
Depending on the movement of the price, each resistance and support level can adopt the role of a pivot point. So, for example, if the price breaks through the R1 barrier then traders can feel confident that it’s a bullish market and the opportunity for potential profit increases. If the price continues upward, R1 essentially becomes the support to R2, which takes on the role of R1, and so forth.
By contrast, if the price moves below PP, then all eyes are on S1, while PP essentially turns into R1. If prices oscillate within this narrow space, between PP and S1, forex traders may find themselves buying at S1 and selling at PP.
Here’s another important tip: if the market is looking bullish, a stop loss order below R1 would provide potential protection from unexpected movements in price. After all, there is no technical tool in this world that can guarantee with absolute certainty what direction the market will move in!
Pivot Point Methods
While most traders and Forex investors use the Standard method (described above) to calculate PP, another four methods are used by technical traders today. These are Fibonacci, DeMark’s, Woodie’s and Camarilla.
Standard, Fibonacci and Woodie’s methods are similar in their formulas because all three take the previous period’s high, low and close prices into consideration. Camarilla is different in that it also factors in the current period’s open price, while the formula for DeMark’s depends on the relationship between the previous period’s open and close price and does not take the main PP into consideration.
The distance between every level (be it PP, S or R) depends on the method used for calculation, and as such, how much reliance is placed on each level differs in relation to the formula. Thus, giving a fitting amount of weight to market sentiment can become tricky for both experienced and novice traders. Taking this into account, many forex brokers have developed a Pivot Points Strategy as an educational tool which doesn’t rely solely on pivot point calculations to determine market direction and sentiment. Using data from three widely used indicators – the MACD (Moving Average Convergence Divergence), Momentum and Moving Average – the goal of the tool is to give the trader a clearer overall picture of the market, so that he (or she) can make more informed decisions.
Want to learn more? Here is a simple guide to learn forex trading.