Pivot traders basically say that the exact value (or price of a stock) at any given time is unknowable. You cannot say that your stock is worth $100 because there are too many variables to contend with. Pivot traders tend to believe that a stock moves between popular values for that stock based on past company performance.
Founded on the unknowable premise, a pivot trader tends to say a stock will trade to levels that it has traded in the past and then pivot - either turn around or "breakthrough" that support or resistance level.
So, pivot traders look at past performance as the best predictor of future performance.
The Pivot point system
The Pivot point system is a technique developed by floor traders to help ascertain where the price is, relative to previous market action. The Pivot point in a very basic sense can be defined as a turning point. It can be classified as a technical indicator derived by calculating the numerical average of the high, low and closing prices, of any financial instrument - currency pair, index or stock. These values are taken from the previous day’s trading range.
A cursory observation of any financial instrument reveals price always fluctuates between levels of support and resistance. Identifying key support and resistance levels can improve the trader’s ability to enter, exit, and manage trades.
The Pivot point is a level at which the sentiment of the market changes. It can be used to predict change in sentiment of traders and investors. The primary advantage of this technique is that it is price-based as opposed to indicator-based. Usually, by the time most indicators generate a signal the move is either completed or already well under way. With the Pivot point system it is possible to execute trades before the indicator-following traders enter the market.
A basic deduction is if the market breaks the Pivot level up then the sentiment is bullish and the market is likely to rise. Similarly, a break of pivot level down is considered bearish and price will continue downwards. Given that the Pivot point is considered a level of support or resistance, a re-test is to be expected. The Pivot point can thus be used as a predictive indicator. If the following day’s market price falls below the pivot point, it may be used as a new resistance level. Conversely, if the market price rises above the Pivot point, it may act as the new support level.
Why pivot trading works
The reason Pivot trading works is that numerous retail traders, investors, bank and institutional traders use and trust the system. It is common knowledge among the trading community that the Pivot point is an important measure of strength and weakness of any market. Floor traders and dealing desks have been applying the methodology for decades in the index, commodity and currency markets. But what separates the profitable traders from the losers is the simple act of following the trend of the day, cutting losses short and letting profits run to the next Pivot value. Pivot points work best on highly liquid markets, like the spot currency market, but they can be used in other markets as well.
Advantages of pivot trading
- Pivot points can be used for determining overall market trend. If the pivot point price is violated in an upward movement, then the market is bullish, and the converse is true. Pivot points are short-term trend indicators useful for only one day until they need to be recalculated. Thus, this condition is likely to sustain only until the next session. Long-term traders utilize weekly Pivot points.
- Pivot point price levels can be used to enter and exit the markets. A trader might put in a limit order to go long if the price breaks a resistance level and use a lower support level as a stop.
- The Pivot points clearly distinguish the support and resistance levels. Consider taking trades when price approaches the support or resistance area. If price is declining and approaching a stage of support level then consider a long trade if this support holds. Similarly, if price is moving higher towards the resistance level consider entering a short trade if this resistance holds.
The S1 support and R1 resistance levels are important. Simply look for reversal or break of R1 or S1. Consider exits rather than entries at extremes (S2, S3, R2 and R3). At these levels the market will already be overbought or oversold.
An Example of Pivot trading - A five-minute chart of the Nasdaq 100 ETF (Nasdaq: QQQ)
In addition to giving buy and sell signals, Pivot points give traders a good time indication as to when to get out of their trade. To illustrate, during a rally some traders will set their sell orders right below the next resistance line. Thus, Pivot point resistance and support lines can generate ready- made profit targets.
In the 5-minute chart of the Nasdaq 100 ETF above, the QQQs opened the day downward, but held steady at Support 1 (S1).
From there, the Nasdaq 100 ETF rallied past the Pivot Point, where it gained additional support. Eventually, the QQQs found resistance at Resistance 1 (R1).
Next, the QQQs meandered slightly above the Resistance Point R1 which then offered support, until finally, the QQQs accelerated past R2.
The rally continued slightly above R2, where the bulls were promptly rejected.
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