free download links about online stock trading, forex, futures, stock investing, market, trading systems
Pivot Point Analysis, Forex Market Trading
Back to contents page

This chapter describes in full detail the principles behind the mathematical calculations that determine pivot point support and resis tance levels, as well as the rationale behind the psychological impact that drives traders to make decisions around these levels. I break the chap ter into separate sections to explain how pivot point analysis can be applied for short- and long-term trading and how it specifically applies to the spot forex market. Each investment vehicle has its own nuances, such as trading session hours, time periods in which volume flows change, contract sizes, and decimal-point placement so that you know how to correctly calculate the pivot point levels. First, you need to know the foundation of the methodology of pivot point analysis so you can apply it to the specific markets of interest that you are trading. My goal is to inform you how to:

• Predict price ranges in a given time period.

• Use the pivot point as a moving average.

• Build a trading system based on the pivot point.

The power in using pivot point analysis is that the strategy works in all markets that have established ranges, based on significant volume or on a large group of collective participants. After all, the current market price equals the collective action of buyers and sellers. Pivot point analysis is a robust, time-tested, and, best of all, testable form of market analysis. This means that you can back-test to see the accuracy of this trader's tool's predictive analysis. The really unbelievable aspect of pivots is who uses them.

However, many novice traders feel compelled not to learn about them be cause they seem complicated. I will dispel that myth.

PIVOT POINT ANALYSIS

This is the best “right side” of the chart indicator, as I like to call it, due to its predictive accuracy. Pivot points are based on a mathematical formula originally developed by Henry Wheeler Chase in the 1930s. Chester W. Kelt ner used part of the formula to develop the Keltner Bands as described in his book, How to Make Money in Commodities (Keltner Statistical Service, 1960).

However, it was really Larry Williams who was credited with repopularizing the analysis in his book How I Made One Million Dollars . . . Last Year . . . Trading Commodities (Windsor Books, 1979). Don Lambert, the creator of the Commodity Channel Indicator (CCI) uses the pivot point for mula that makes the CCI work.

In my first book, A Complete Guide to Technical Trading Tactics (Wiley, 2004), I illustrated many trading methods that one can apply using pivot point analysis combined with candlestick patterns, including the ad vantage of trading using multiple time frames, or what is know as a conflu ence of various target levels based on different time periods. This chapter will highlight those techniques as well as explain how to incorporate the pivot point as a moving average trading system and how to filter out and narrow the field of the respective support and resistance numbers and will divulge various formulas that are popular today.

As I said, pivot points are a mathematical formula designed to deter mine the next time period's range based on the previous time period's data, which includes, the high, the low, and the close or settlement price. One reason why I believe in using these variables from a given time period's range is that it reflects all market participants' collective perception of value for that time period. The range, which is the high and the low of a given time period, accurately reflects all market participants' exuberant bullishness and pessimistic bearishness for that trading session. The high and the low of a given period are certainly important, as they mirror human emotional behavior. Also, the high is a reference point for those who bought out of greed, thinking that they were missing an opportunity. They certainly won't forget how much they lost and how the market reacted as it declined from that level.

The opposite is true for those who sold the low of a given session out of fear they would lose more by staying in a long trade; they certainly will respect that price the next time the market trades back at that level, too. So the high and the low are important reference points. With that said, the

pivot point calculations incorporate the three most important elements of the previous time period: the high (H), the low (L), and, of course, the close (C) of a given trading session. First, let me give you the actual mathematical calculations, and then I will go over what each level represents.

• Pivot point—the sum of the high, the low, and the close divided by three.

P = (H + L + C)/3

• Resistance 2 (R-2)—pivot point number plus the high minus the low. R-2 = P + H - L

• Resistance 1 (R-1)—pivot point number times two minus the low. R-1 = (P ? 2) - L

• Support 1 (S-1)—pivot point number times two minus the high. S-1 = (P ? 2) - H

• Support 2 (S-2)—pivot point number minus the high plus the low. S-2 = P - H + L

Some analysts are adding a third level to their pivot calculations to help target extreme price swings that have occurred on certain occasions, such as a price shock resulting from a news event. I have noticed that the spot forex currency markets tend to experience a double dose of price shocks because they are exposed to foreign economic developments and

U.S. economic developments that pertain to a specific country's currency. This tends to make wide trading ranges. Therefore, a third level of pro jected support and resistance was calculated.

• Resistance 3 (R-3)—the high plus two times (the pivot minus the low) R-3 = H + 2 ? (P - L)

• Support 3—the low minus two times (the high minus the pivot) S-3 = L - 2 ? (H - P)

or

R-3 = P - S-2 + R-1
S-3 = P - R-2 - S-1

There are other variations that include adding the opening range, which, in this case, would involve simply taking the sum of the high, the low, and the open, and the close and dividing by four to derive the actual pivot point.

P = (O + H + L + C) /4

Since there is no formal closing and opening range, forex traders can use the N.Y. bank settlement as the close at 5 P . M . (EST) and assign the next day's session open as 5:05 P . M . (EST).

The following list shows what these numbers represent, how price ac tion reacts with these projected target levels, how the numbers would break down by order, what typically occurs, and how the market can be have at these levels. Keep in mind that this is a general description, and we will learn what to look for at these price points to spot reversals in order to make money. I must stress that it is important to look at the progressively higher time period's price support or resistance projections; for example, from the daily numbers, look at the weekly figures; and then from the weekly numbers, look at the monthly numbers. The longer the time frame, the more important or significant are the data. Also, it is rare that the daily numbers trade beyond the extreme R-2 or S-2 numbers; and when the market does, it is generally in a strong trending condition. In this case, we have methods to follow the market's flow, and we will cover them in more detail in the next few chapters. Remember, pivot point analysis is used as a guide; these numbers are not the holy grail. By focusing on just a few select num bers and learning how to filter out excess information, I eliminate the analy sis paralysis from information overload.

• Resistance Level 3—This is the extreme bullish market condition gen erally created by news-driven price shocks. The market is at an over bought condition and may offer a day trader a quick reversal scalp trade.

• Resistance Level 2—This is the bullish market price objective or target high number for a trading session. It generally establishes the high of a given time period. The market often sees significant resistance at this price level and will provide an exit target for long positions.

• Resistance Level 1—This is the mild bullish to bearish projected high target number. In low-volume or light-volatility sessions or in consoli dating trading periods, this often acts as the high of a given session. In a bearish market condition, prices will try to come close to this level but most times will fail.

• Pivot Point—This is the focal price level or the mean, which is derived from the collective market data from the prior session's high, low, and

close. It is the strongest of the support and resistance numbers. Prices normally trade above or below this area before breaking in one direc tion or the other. As a general guideline, if the market opens above the primary pivot be a buyer on dips. If the market opens below this level, look to sell rallies.

• Support Level 1—This is the mild bearish to bullish projected low tar get number in light-volume or low-volatility sessions or in consolidating trading periods. Prices tend to reverse at or near this level in bullish market conditions but most times fall short of hitting this number.

• Support Level 2—This is the bearish market price objective or targeted low number. The market often sees significant support at or near this level in a bearish market condition. This level is a likely target level to cover shorts.

• Support Level 3—In an extremely bearish market condition, this level will act as the projected target low or support area. A price decline to this level is generally created by news-driven price shocks. This is where a market is at an oversold condition and may offer a day trader a quick reversal scalp trade.

Weekly and monthly time frames can and should be utilized as well as the daily numbers you may be used to or have heard about in the past. To understand how price moves within the pivots, begin by breaking down the time frames from longer term to shorter term. As traders, we should begin with a monthly time frame, where there is a price range or an established high or low for a given period. This range, with its price points, is what we as traders should be looking for. Here is how I utilize the range in my re search. There are approximately 22 business days, or about 4 weeks, in each month. Every month there will be an established range—a high and a low. There are typically five trading days in a week. Now consider that in one day of one week in one month, a high and a low will be made. It is likely that this high and low may be made in a minute or within one hour of a given day of a given week of that month. That is why longer-term time frames, such as monthly or weekly, should be included in your market analysis. In the world of 24-hour trading, the most popular question I get from those studying and using pivot points is, “What are the times that you derive the high-low-close information?” There are many different people telling many different stories. Here is what I do and what seems to work the best for me. For starters, just keep things simple, and apply some good old fashioned common sense. If the exchanges and the banking system use a specific time to settle a market, then that is the time period that should be considered for a “close.” They should know those are the rules that make money move. I want to follow the money flow and be on the same time schedule as the banks and institutions, so here are a few pointers:

Use the 5 P . M . (EST), New York bank settlement close to determine pivots.

• For the weekly calculations, take the open from Sunday night's session and use the close on Friday.

• For the monthly calculations, take the opening of the first day of the month and the close from the last day of the month.

I believe in keeping things simple because trading requires split-second decisions. Therefore, it is important not to be burdened with information overload. Remember:

• Pivot point calculations help determine when to enter/exit positions.

• Pivot points help as leading price indicators for traders.

• Pivot points are used to project support and resistance or actual highs and lows of trading sessions.

• Pivot points help confirm other technical methods.

• Daily, weekly, and monthly time frames should and can be used.

Remember these issues: In every week, there are five trading days. In every month, there will be an established range, in other words, a high and a low. In one day of one week in one month, a high and a low will be made. It is likely that the high and the low may be made in a minute or an hour of a given day of a given week in that month; that is why longer-term time frames, such as a monthly or weekly analysis, should be used. Pivot point analysis relies on specific time frames in determining support and resis tance levels for that timing element only and infers that the analysis or calculations for the prior day will not be applicable in most cases two, three or four days later. The same principle goes for the weekly and monthly calculations; so at the end of that time period, new data must be recalculated.

Smarter trading The art of day trading Trading Chaos Sane Investing In An Insane World
Beat The Odds In Forex Trading Robert Kiyosaki - Rich Dad, Poor Dad
The Five Rules For Successful Stock Investing Joe DiNapoli - Trading with DiNapoli Levels
Alexander Elder - Trading for a living