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PIVOT POINT MOVING AVERAGE FOREX TRADING SYSTEM
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The moving average is one of the most widely utilized indicators in techni cal analysis because the moving average is easy to identify and easy to back-test. Many automated trading systems use moving averages or some derivation of a moving-average method to generate buy and sell signals. Moving averages are considered classic indicators and are very popular with traders today. Most technicians view the moving average as a way to signal a change in the direction of the trend, as well as a way to smooth out the volatility of the market.

The Simple Moving Average

The simple moving average (the arithmetic mean) is the most popular mov ing average used in technical analysis. The simple moving average is the sum of the closing prices over several sessions divided by the number of sessions. For example, a 20-day moving average would be the sum of the preceding 20 days' closing prices divided by 20. As new data is added to the calculation, old data is removed: Each new day would drop the first day's closing price and add the new day's closing price. By averaging the price data, a smoother line is produced, and the trend is much easier to recog nize. The disadvantages of the simple moving average are that it only takes into account the time period of the sessions covered in the calculation and it gives equal weight to each day's price.

The moving average is the average of the closing prices (sometimes re ferred to as the settlement price) of a defined number of sessions. The moving average is a lagging indicator. The purpose of the moving average is to indicate the beginning and the ending of a trend. Since the moving average follows the market, the signals it generates occur after the trend has already changed.

It has been postulated that most traders lose their money in the markets. If most traders focus on moving-average values that are predeter mined by default settings in their charting software packages or that use the media's favorite 200-day moving average, it's no wonder they lose. They are all following the same indicator, and a tremendously lagging indicator at that!

Be Smarter and Faster Than the Next Guy

If you want to make consistent profits, then you need to think and use a dif ferent set of values or understand how signals are generated. Also, you do not want to follow and base your trading strategies on what everyone else is looking at to enter or exit positions. So when it comes to moving aver ages, you want to look at different sets of conditions and time periods. Think for just a minute: If lots of traders are watching for trade signals on 20-, 50-, 100-, or 200-period moving averages, and if it is true that the ma jority of traders lose money, then why do I want to take trade signals based off those moving-average values? Some traders and technical analysts use various ways to calculate such moving averages as the simple, the weighted, and the exponential. I prefer the simple moving average and a dif ferent set of values for my moving average, namely the pivot point. As you will recall, the pivot point calculation provides the mean (average) for the session's trading range (P = H + L + C/3).

The moving-average section discusses how the moving average helps clarify the market's price flow by extending price analysis over a certain pe riod of time. In this manner, moving averages can demonstrate when a mar ket enters an extreme condition by how far it departs from the mean. Price action will move toward either the moving average in which it acts as a sup port or the resistance number. What I use is the combination of the price session information (H + L + C/3) known as the pivot point number over a specific period of time (moving average). This value utilizes cumulative data from the high, the low, and the close for a session; and, more impor tant, the information provides a clear picture of the “average true price” for that time period. This moving average value I use is calculated by taking the pivot number from the past three periods. The time frames I use are daily, weekly, and monthly periods. It is important to note, however, that the longer the time frame, the more significance the number will hold. To calculate the market direction number, add three pivot points from the same session and divide by three. The purpose of using the pivot point as a moving-average calculation is that the pivot point gives me a truer sense of market value for a given period in time.

The three-period pivot point moving average can act as a support num ber in bullish conditions and has a high degree of importance when one of the pivot point calculations for the current session coincides with the mov ing average or is close to it. This value holds true as a resistance number in a bear market condition. If other numbers coincide with the pivot point moving average, such as the actual pivot point or an R-1 number, then it would serve as the target high number for that specific time period. An other way of using the three-period pivot point moving average is as a point of reference or fair value. When the market price departs or deviates too far from the mean, then you can use the extreme support or resistance num ber, such as S-2 or R-2, or the farthest target number of that direction as a potential turning point.

When various time frames are incorporated into the analysis (daily, weekly, and monthly), there is more certainty that the target price level can generate the anticipated reaction. If the market gaps too far from the daily pivot point moving average, use the monthly and/or weekly target support and resistance numbers to help identify a targeted reversal support or resistance point.

Figure 2.15 shows a spot forex British pound daily chart with the threeperiod pivot point moving average overlaid on top of prices. Notice that as the market changes conditions from bullish (uptrend) to bearish (down trend), prices tend to bounce off the moving average as a support line and trade off the moving average as a ceiling of resistance. You should also no tice the topping price action. Now if we start with point A, you will see that point B is higher in price. Look at the corresponding points in the moving average values, and you will see that point B makes a higher high; but the moving average value is lower than when it is at point A. This is what I iden tify as a moving-average divergence. It serves as a strong clue that the mar ket has peaked and that a significant reversal is due. Pivot point moving averages can help you filter out market noise (ranges) and can give you a truer picture of the market's value and direction.

The time period between point A and point B was a consolidation phase, as prices moved above and below the moving average. The moving average went virtually in a flat line with a bias to a downside slope. This was hinting that prices were getting ready to change direction. When you watch the moving average in relationship to the underlying price action, sometimes you can get clues as to the true market price direction using the pivot point average because it factors in the overall range and the relation ship that the close of each time period has to that range. If the close is closer to the high, the average will be at a higher assigned value. As I just stated, using the three-period pivot point average will help you filter out much of the market noise and give you a truer sense of the market's fair value within the price range of the past three trading periods. This is very helpful information because forex markets do go in range-bound consoli dation periods. These are called sideways channels, which we will discuss in the next few chapters.

At times, the slope (or the angle) of the moving average can give you a clue as to the market's true strength or weakness, especially when com bined with candlestick charting. The slope helps filters out the noise and shows you whether the market's value is progressively appreciating or de preciating. When a market goes from the trending phase into the consoli dation phase, it is the slope of the pivot point moving average that can help you identify the next potential price direction from the consolidating phase (e.g., a continuation or a trend reversal move). For added clarity, when you use a pivot point moving average combined with the ability to identify a high-probability bottom- or top-forming candle pattern, you have added confirmation of a potential reversal move. The graph in Figure 2.16 shows a representation of a pivot point moving average in a declining trend phase. Then as prices consolidate, the pivot point average measures the typical price rather than the close; and we can, therefore, determine what the true market value is and which way prices tend to be moving. Markets some times demonstrate extreme volatility at turning points. The moving average approach can help filter out the noise inflicted by wide price swings. These swings often lead to confusion; or, worse, traders get whipsawed or chewed up.

As the moving average slopes upward, it indicates that the market val ues are also tending to trade higher. Eventually, we see a trend reversal, which is what the direction of the moving average indicated. The three period pivot point moving average works as a tool to confirm triggers and exits by showing price action closing above or below the moving average pivot line as well as indicating the potential trend direction by looking at the trend direction of the moving average itself. In Figure 2.17, I have a 30 minute chart on the spot forex British pound. Looking at the consolidation period as formed by an ascending triangle, we see that the market is start ing to change from a bearish trend condition to a consolidation phase; and the upward slope of the moving average is giving a clue that the market may move into a reversal. This is the clue you are looking for to make money by watching for the reversal to occur, then entering in the market as it moves to ride the momentum so you can profit. Trading is not about being bullish or bearish, but just being in the market, on the right side, when it does move. That's how you will consistently make high-probability and profitable trades.

The British pound chart in Figure 2.18 provides a good example of the follow-through to the upside; and as prices continue higher, we see more bullish confirmation that the market will continue to the upside with a ham mer candle pattern.

As the market starts to move upward by establishing higher highs and higher lows, you can see that it is also closing above prior highs and, most important, closing above the three-period pivot point moving average. The pivot point moving average will now start to act as a trend support.

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