This week we’re playing with pivots. No, we’re not talking fancy gadgets here.. We’re going to learn how to make use of technical indicators called pivots when making our trades. Pivots play a crucial role as far as identifying support and resistance levels on the charts. They’re more like robots with the mentality of sniffer dogs as their job is to ascertain the overall trend direction of the market.
So we’re going to breakdown the pivots three way.We’ll explain what pivots are.Then we’ll learn how to caculate the pivots, and finally we’ll learn how to trade the pivots.
What really are Pivots?
Well,pivots are these indicators that help the trader determine the overall trend in a market over different time frames. The pivot points simply average the points from the previous trading day. These pivot points are absolutely immense.Why? because they’re the means by which forex traders support and resistance areas. In plain English, the pivot points and their surronding support/resistance levels are most likely to experience change in the direction of price movement.
This then begs the question.
Why are forex traders so crazy about pivots?
Well, it’s very simple. They tell things as they are on the charts.You don’t get any pussy footing or any discretionary moves from pivots.They just give it to you straight as far as the happenings on the charts are concerned. Because so many people have their eagle eyes set on these support/resistance levels, these zones confirm the traders worst suspicions. However, pivots can be a bit subjective as far as spotting the highs and lows are concerned.
Pivot points are also valuable to short term traders.Why? Because they create opportunities to cash in on price movements. Also, forex traders have the luxury of choosing to trade the bounce or break like normal support and resistance levels. Those who trade range-bound markets use reversals.They see zones as great opportunities to place their orders. While breakout traders use pivot points to detect key levels that must be broken or penetrated.
This is a beautiful illustration of pivots at work. Notice how the support and resistance levels and pivot point are nicely labelled on the chart. Doesn’t get any better than this. Now before I continue let me give you a run down on the meaning behind those acronyms on the charts. Not to worry!They’re not CB radio signals.
PP = Pivot Point
S = Support
R = Resistance.
Which brings us to:
How to Calculate Pivot Points
Boys and girls grab your calculators because we’re going to do a little Math. We ‘are going to learn how to calculate pivot points. But before I get started, let me say this: If you have a phobia, about algebra,or you hate algebra with a passion, not to worry! In most cases, the software behind the charts does the calculations. You don’t need to crack your brains too much. But for you Math nuts, let’s get cracking.
Basically, we are calculating the pivot point and the surrounding support and resistance levels. And do to accomplish this task, we make use of the previous trading session’s open, high, low and closing prices.
To calculate the pivot point the formula goes like this:
Pivot Point (PP) = (High + Low + Close) / 3
You then calculate the support and resistance levels off the pivot point in this direction:
First level support and resistance:
First Resistance (R1) = (2 x PP) – Low
First Support (S1) = (2 x PP) – High
Second level of support and resistance:
Second Resistance (R2) = PP + (High – Low)
Second Support (S2) = PP – (High – Low)
Third level of support and resistance:
Third Resistance (R3) = High + 2(PP – Low)
Third Support (S3) = Low – 2(High – PP)
Quick alert!Some price chart software plot intermediate levels, or what we call midpoint levels. Here is how they look like on the charts
As you can see all the levels are nicely labelled for you comfort, thanks to the backend workings of the software. Most forex charts software automatically calculate these points like clock work for you. The only thing you have to do is just configure your settings for the software to deliver to you the closing time and price. See how stressless this is?
You may also want to arm yourself with pivot calculator . You will definitely need it especially when it comes to backtesting to check prices reaction to pivot points. You’ll be amazed at how honest the pivot points are. They just tell you exactly how the prices react to their presence on the charts. Getting a pivot calculator is not that difficult. I believe most brokers provide you with one. Or if you prefer,you can download it online. Just Google pivot calculator and Google’s search spiders will be only too glad to oblige.
Now that we’ve gotten the math out of the way, let’s get to the most exciting part – THE TRADING!
We’re going to cover three parts . The first part is
How Do I Use Pivots to Trade Ranges?
Well the easiest way to use pivots as part of your forex trades is to treat them like typical support and resistance levels. And if you know prices as well as I do, when they see support and resistance levels, they hit them repeatedly in their attempt to break through and head for the hills. And if these levels are able to withstand a currency pair’s constant barrage,then it means these levels have a strong backbone. So applying the description of the support/resistance levels to the pivot point, your pivot level is able to withstand the currency pair’s onslaught this creates great opportunities for you. And these opportunities could come in the following waves:
- If a price is closing in on the resistance level, sell the pair and put a stop loss just above the resistance
- If you see the price inches ever closer to the to the support level, buy the pair and put a stop just below the support level.
Nothing to it at all. Let’s see the actual representation of this range trade
As you may have noticed, price is testing the resolve of S1(Support Level 1). If you believe in your heart of hearts that S1 can repulse the price, put in your buy order just above S1. Of course you want to safeguard your trading position, so you put in a stop loss past the next support level.
If you want to play it safe, you can set a wide stop just below S2. However,if price breaches the barriers of S2,the probability of i turning around and going uphill is unlikely as both SI and S2 would have converted from support to resistance levels. But if you want to be bold, and you are 100 percent certain S1 will hold its ground, just place your wide stop loss just below S2.
Some of you are wondering”Where do we place our take profits?” Well, you could place your profit targets , you could aim at PP or R1. Then again these two levels could put up some resistance. So watch out for that. Anyways let’s see how the market looks when you place your buy order.
Voila! S1 survived the onslaught! And if your “Take Profit” is PP it means “Take the money to the bank” However, a little news flash! It’s not always that straight forward. You shoudn’t always put all your pivot point eggs in one basket. Make sure your pivot point levels are parallel with the previous support and resistance levels. To help you get confirmation of a trade, just fall back on your candlestick analysis. And if you’re not sure about your candlestick knowledge read up on You Need To Know Ten of These Candlestick Patterns.
Last but not least:
How Do I trade Breakout with Pivots?
First you need to support the support and resistance levels. As I’m sure you know by now, support/resistance levels can’t sustain a rearguard action forever. At some point, they’re bound to cave in. And when that happens, you get to work with your trades. As we found out earlier, you can trade it safe, or you can go aggressive. However,for those who like to play it play it safe,you ;d be better off taking advantage of the initial breakout. Why? because if you’re waiting for a retest of the support/resistance barriers, you may end up missing out on huge trading opportunities. Let’s see how pivots points scout potential trades in this graphic
We see price surge above PP before cooling down at R1. Eventually the resistance barrier at R2 caveS in, giving the bulls free passage to surge by a further 50 pips. This shows the dividends of trading the aggressive way if your eyes are sharp enough to catch the initial price action. However, if you’re sitting there waiting for price to take a second bite at the cherry(or retest), you’d be waiting in vain. As you can see,price chose not to come back. It continued on upwards.
See how the bulls try to attack the resistance barrier at R3. You do not want to adopt the same aggressive posture here like you did at PP. Why?because this is false break territory. Failure to take heed could result in a huge loss for your trading position, not to mention,spike your blood pressure. And if your stop loss is too close for comfort, you’d most certainly get swamped. So your best option would be to take the safe option.
If you want to learn how the false break strategy works read up on Trade The False Break
Notice how the bulls break out after the initial resistance by the bears. Also pay attention to how the bulls make a U-turn and break down past R3. You could go short(or put in a sell entry) at the retest of the broken line.
Last but not least:
Where Do I Place Stop Losses And Profit Targets In Breakouts
Hmmm……placing stop losses and profit targets in breakouts is not an exact science. Why?because unlike range trades where your focus is on breaks of support and resistance, you are looking for strong fast Usain Bolt-like surges in the breakout. It’s like keeping up with the speed of light. If you choose to go long(buy) and price fizzles out at R1, you could place a stop below R1. Let’s take a look at the previous graph again.
As you can see price slightly cooled at R1. In this scenario,you place your stop loss at R1. Better safe than sorry if you ask me.
Speaking of setting targets, here is what you do. Aim for the next pivot point support or resistance level.By the way if you’re expecting price to break through at all levels, DREAM ON! The only time this miracle happens is when a major economic event or surprise news occurs. Whether this news is good news,your guess is as good as mine. Let’s take a look at the previous graphic and see where the stops are placed.
As you can see, the bulls break through at R1. In that case you place your stop just below R1 to protect your position from nasty unexpected U-turn. Keep vigil over your position and move your stop to see if the pattern continues.
That’s a wrap for “Playing With Pivots ” Pivots can be fun to trade trade with. They help catch profitable trades that the naked eye misses. If you place them properly on your chart, you could have yourself a major harvest.
Til next time take care.
If you’re looking to open a live trading account sign up with EasyMarkets.