Forex Walkthrough

Trading - Pivot Points

For many years, traders and market makers have used pivot points to identify critical support and/or resistance levels. Pivots are also frequently used in the forex market and can be an extremely useful tool for range-bound traders to identify points of entry and for trend traders and breakout traders to spot the key levels that need to be broken for a move to qualify as a breakout. In this section, we'll explain how pivot points are calculated, their applications in the forex market, and how they can be combined with other indicators to develop alternative trading strategies.

Calculating Pivot Points
By definition, a pivot point is a point of rotation. The input prices used to calculate the pivot point are the previous period's high, low and closing prices for a security. These prices are typically taken from a stock's daily charts, but the pivot point can also be calculated using information from hourly charts. Many traders prefer to take the pivots, as well as the support and resistance levels, off of the daily charts and then apply those to the intraday charts (for example, every 60 minutes, every 30 minutes or every 15 minutes). If a pivot point is calculated using price information from a shorter time frame, this tends to reduce its accuracy and significance.

The textbook calculation for a pivot point is as follows:

Central Pivot Point (P) = (High + Low + Close) / 3


Support and resistance levels are then calculated off of this pivot point using the following formulas:

First level support and resistance:

First Resistance (R1) = (2*P) - Low
First Support (S1) = (2*P) - High


Likewise, the second level of support and resistance is calculated as follows:

Second Resistance (R2) = P + (R1-S1)

Second Support (S2) = P - (R1- S1)


Common practice is to calculate two support and resistance levels, but it's not unusual to derive a third support and resistance level as well. (However, third-level support and resistances are a bit too esoteric to be useful for the purposes of trading strategies.) It's also possible to go further into pivot point analysis - for example, some traders go beyond the traditional support and resistance levels and also track the mid-point between each of those levels.

Applying Pivot Points to the FX Market
Generally speaking, the pivot point is seen as the primary support or resistance level. The following chart is a 30-minute chart of the currency pair GBP/USD with pivot levels calculated using the daily high, low and close prices.

The green line is the pivot point (P).

The red lines are resistance levels (R).

The blue lines are support levels (S).

The yellow lines are mid-points (M).

Figure 1 demonstrates how the pivot line served as support for the GBP/USD pair for most of the European trading hours. Once the U.S. market opened and U.S. traders joined the market, however, prices began to break higher, with each of the breaks first testing and resisting either the midpoint or the R1 and R2 levels; then the break occurred off of those levels (see areas circled). This chart also shows something that occurs often in the forex market, which is that the initial break occurs at a market open. There are three market opens in the FX market: the U.S. open, (at approximately 8am EST), the European open (at 2am EST), and the Asian open (at 7pm EST).

Figure 1: This chart shows a common day in the FX market. The price of a major currency pair (GBP/USD) tends to fluctuate between the support and resistance levels identified by the pivot point calculation. The areas circled in the chart are good illustrations of the importance of a break above these levels.
Source: FXTrek Intellicharts


What we also observe when trading pivots in the forex market is that the trading range for the session usually stays between the pivot point and the first support and resistance levels because a large proportion of traders play this range. In Figure 2 (a chart of the USD/JPY), you can see in the areas circled that prices initially stayed between the pivot point and the first resistance level with the pivot acting as support. Once the price broke through the pivot level, the chart moved lower and stayed predominately within the pivot and the first support zone.

Figure 2: This chart shows an example of the strength of the support and resistance calculated using the pivot calculations.
Source: FXTrek Intellicharts
The Significance of Market Opens
A key point to understand when trading pivot points in the forex market is that breaks tend to occur around one of the three market opens. The main reason for this is the immediate influx of traders entering the market at the same time. These traders all go to the office at roughly the same time, take a look at what happened overnight and then adjust their portfolios accordingly. During the quieter time periods, such as between the U.S. close (4pm EST) and the Asian open (7pm EST) (and sometimes even throughout the Asian session, which is the quietest trading session), prices may remain confined for hours between the pivot level and either the support or resistance level. This provides the perfect environment for range-bound traders.
Two Strategies Using Pivot Points
Several strategies can be developed using the pivot level as a reference point, but the accuracy of using pivot lines increases when Japanese candlestick formations can also be identified. For instance, if prices traded below the central pivot (P) for most of the session and then made a foray above the pivot while simultaneously creating a reversal indication (such as a shooting star, doji or hanging man), you could sell short in anticipation of the price resuming trading back below the pivot point.
A perfect example of this is shown in Figure 3, a 30-minute USD/CHF chart. The USD/CHF had remained range-bound between the first support zone and the pivot level for most of the Asian trading session. When the Europe market opened, traders began taking the USD/CHF higher to break above the central pivot. Bulls lost control as the second candle formed into a doji formation. Prices then began to reverse back below the central pivot to spend the next six hours between the central pivot and the first support zone. Traders watching for this formation might have sold USD/CHF in the candle right after the doji formation to take advantage of at least 80 pips worth of profit between the pivot point and the first level of support.
Figure 3: This chart shows a pivot point being used in cooperation with a candlestick pattern to predict a trend reversal. Notice how the descent was stopped by the second support level.
Source: FXTrek Intellicharts
Another strategy traders can use is to look for prices to obey the pivot level, therefore confirming the level as a valid support or resistance zone. In this type of strategy, you're looking to see the price break the pivot level, reverse and then trend back toward the pivot level. If the price proceeds to drive through the pivot point, this is a sign that the pivot level is weak and likely not useful for trading decisions. However, if prices hesitate around that level or "validate" it, then the pivot level is much more significant and suggests that the move lower is an actual break, which indicates that there may be a continuation move.
The 15-minute GBP/CHF chart in Figure 4 shows an example of prices "obeying" and validating a pivot line. Initially, prices were trading between the mid-point and pivot level. At the European open (2am EST), GBP/CHF rallied and broke above the pivot level. Prices then reverted back to pivot level, held it and proceeded to rally once again. The level was tested another time right before the U.S. market open (7am EST), at which point traders should have placed a buy order for GBP/CHF since the pivot level had already proved to be a significant support level. Traders who did were rewarded as the GBP/CHF rallied again.
Figure 4: This is an example of a currency pair "obeying" the support and resistance identified by the pivot point calculation. These levels become more significant the more times the pair tries to break through.
Source: FXTrek Intellicharts
Conclusion
Traders and market makers have been using pivot points for years to determine critical support and/or resistance levels. As seen in our examples, pivots can be especially popular in the forex market since many currency pairs do tend to fluctuate between these levels. Range-bound traders will enter a buy order near identified levels of support and a sell order when the asset nears the upper resistance. Pivot points also allow trend and breakout traders to spot key levels that need to be broken for a move to qualify as a breakout. Furthermore, these technical indicators can be especially useful at market opens.
Having an awareness of where these potential turning points are located is an excellent way for individual investors to become more attuned to market movements and make more educated transaction decisions. Given their ease of calculation, pivot points can also be incorporated into many trading strategies. The ease of use and flexibility of pivot points definitely makes them a useful addition to your trading toolbox. In the next section, we'll take you through another advanced topic - the use of bond spreads as a leading indicator for the forex market.


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