Pivot Points Background
In recent years pivot points have become a very well known and widely used technical analysis tool. Key to understanding pivot point levels is the idea of support and resistance. Support and resistance levels give traders a visual gauge of pressure points within the market, specifically at certain price levels.
In Technical Analysis the following excerpt explains support and resistance levels as applied in the stock market; the same principles are also applicable to the currency market.
"A support level is a price level at which sufficient demand for a stock appears to hold a downtrend temporarily at least, and possibly reverse it. i.e., start prices moving up again. A resistance zone by the same token, is a price level at which sufficient supply of stock is forthcoming to stop, and possibly turn back, its uptrend. There is, theoretically, a certain amount of supply and a certain amount of demand at any given price level... But a support range represents a concentration of demand, and a resistance range represents a concentration of supply."
The above was taken from a guest course in the University. Content for this course was taken from chapter 7 of Clif Droke's book Technical Analysis Simplified
Summary of Support & Resistance:
To summarize the above, support levels are considered levels at which price decline is continually rejected. Conversely, resistance levels are considered levels at which price increase is continually rejected. Traders looking at a support level and resistance level in conjunction with one another are essentially examining what is referred to as a channel. It is very common to see price trends within the bounds of trading channels; meaning that for hours, or perhaps days at a time, a currency may trade within the bounds of support and resistance levels. Many times throughout a trend the price may test either the support or resistance level, but ultimately if the price is to remain within the channel the support and resistance levels will be tested, but not pushed through.
Just the opposite of what is explained above, if a support or resistance level is tested for hours or days on end without a breakout, and finally the price does push through the bounds of this channel, it may be considered a strong indication that the price will take on an entirely new direction / trend.
Using Support & Resistance to Trade:
Traders watching support and resistance levels are generally looking for one of the following trading opportunities:
A chance to sell after a resistance level has been pushed, but not broken through several times. The trader's entry would likely be at the end of a strong bearish candle that began with a touch of the resistance level.
A chance to buy after the support level has been pushed, but not broken through several times. The trader's entry would likely be at the end of a strong bullish candle that began with a touch of the support level.
A chance to buy after a previously tested resistance level is finally pushed through with a strong bullish candle. In other words, buyers in the market have tried numerous times to push prices above a resistance level, yet have failed. Finally prices breakthrough in the form of a strong up-candle, indicating that perhaps, buyers will finally have their way and push the price higher.
A chance to sell after a previously tested support level is finally pushed through with a strong bearish candle. In other words, sellers in the market have tried numerous times to push prices below the support level, yet have failed. Finally prices breakthrough in the form of a strong down-candle, indicating that perhaps, sellers will finally have their way and push the price lower.
Understanding the Pivot Point Difference:
As is explained above, there are multiple scenarios in which a trader might utilize support and resistance levels as a means to indentify key entry and exit points. Pivot points are very similar to support and resistance levels, in fact, pivot points are simply a series of support and resistance levels, with the inclusion of a median price level. Standard pivot points include 5 levels (levels that are represented as distinct lines on your charts). The median level, or middle line of the 5, is called the pivot point'. The other 4 levels are found above and below the pivot point in the form of 2 support lines (S1 and S2) and 2 resistance lines (R1 and R2).
Using the previous trading session's open, high, low and close in order to calculate these pivot levels gives traders an added advantage beyond simply looking at one support level and one resistance level. Through the use of pivot points traders are able to gauge support and resistance levels on a scale in relation to an average price range (the pivot point or line itself) for the trading session.
As is the case with many forms of technical analysis, the actual math of pivot points in terms of its ability to predict price movement is certainly questionable. But, experienced traders understand that the science of the math is completely irrelevant. Rather, what does matter is that so many traders are utilizing pivot points as a means to gauge support and resistance levels. Always bear in mind the crucial importance of market sentiment; mathematically pivot points may or may not correlate with future price movement, but because pivot points are now very widely used by technical traders - their potential to impact price direction is certainly worth considering. Said another way, if millions of technical traders are all watching the same support and resistance levels and buying and selling in accordance with those levels; market sentiment can quickly become market reality. Pivot points may be as effective as they are at times simply because so many traders are basing trades on the same levels. Or, perhaps, there is magic found in these simple calculations.
Calculating Pivot Points:
Pivot point calculations are actually quite simple. Key figures are derived from the open, high, low and closing price of the previous day's trading session. These figures should be based on trading days or sessions considered started and ended at 0:00 GMT (Greenwich Mean Time). GMT is used because of the global aspect of currency trading; with various markets (Australia, Asia, Europe, US) constantly opening and closing globally - a 24-hour-a-day market is created. GMT is used to mark the start and end of trading days because it is considered a globally central time.
The actual calculations for pivot points are outlined below, though please do not fret; these calculations are shown for your reference, but will not need to be mastered in order to utilize pivot points:
Pivot Point (PP): High + Low + Close / 3
The subsequent calculations for support and resistance levels are based on the number calculated for the pivot point itself and are as follows:
First Support (S1): (2 x PP) - High
Second Support (S2): PP - (High - Low)
First Resistance (R1): (2 x PP) - Low
Second Resistance (R2): PP + (High - Low)
As is the case with many technical analysis methods, strategies, and indicators - pivot points are far from an exact science. Though various trading methods were outlined above in the using support and resistance levels to trade' section, these methods are simply an outline of how a technical trader might use support and resistance or pivot points in their trading process. A seasoned trader would take into account other factors that will most certainly impact the market, a factor such as major fundamental indicators (news announcements). Pivot points may be completely irrelevant technically when trading right after a major fundamental news announcement. Traders should also consider other technical indicators, the overall trend of the currency pair, and the time frame of the chart they are analyzing pivots on in correlation with how long they plan to remain in an open position.
Typically, pivot points tend to work well if traders understand a few of the following tips, tips that might otherwise only be learned from rough experience.
Prices tend to volley between two pivot lines, in other words if a price is right at S1 it is most likely to move back toward PP, only a fairly strong bearish candle would indicate a further break and move towards S2. Just the same, if a price is at R1 it is most like to move back towards PP and only a strong bullish candle would indicate a move towards R2. When prices are trading at the pivot line itself, look for a strong series of bullish or bearish candles to indicate a move back towards R1 or S1.
Pivot points seem to work the best in moderately sideways markets, or on a currency pair that is not experiencing significantly strong bullish or bearish trend over the previous few days.
Prices within pivot points can move two or three lines at a time during major news announcements, or what is more likely; pivot points may be completely irrelevant during news announcements.