Profit potential is increased when a trader understands and uses pivots. The term pivot refers to a turning point in the price of an asset and often coincides with key levels of support and resistance. There are two basic types of pivots: calculated pivots (those determined by using mathematical formula) and price pivots (determined by looking at the price action on a chart). In this article we'll focus on price pivots and show how they can be successfully implemented into an active trading strategy.
Types of Pivots
A calculated pivot, often called a floor trader pivot, is derived from a formula using the previous day's high, low and closing price. The result is a focal price level about which price action is likely to turn, either up or down. Calculated pivots represent potential turning points in price, while price pivots are actual historic turning points. (See also: Using Pivot Points for Predictions.)
Price pivots are not calculated. The pivot is defined by the structural relationship between price bars. Price pivots form on all time frames, are building blocks of trend and provide objective entry and exit points for trading.
Price pivots are best conceptualized with three bars. A three-bar pivot low represents support and is formed when buying pressure turns price from down to up. It is designated by a price bar with a higher low that closes above the previous bar's high, where the previous bar's low is lower than the bar that preceded it. This is true in every time frame.
A three-bar pivot high represents resistance and is formed when sellers turn price from up to down. It is seen where a price bar with a lower high closes below the previous bar's low, where the previous bar's high is higher than the bar that preceded it. Structural pivots are more easily recognized and understood when seen in a diagram or on a price chart. This is true in every time frame. (See Figure 1)
Figure 1: These three-bar formations create the pivot low/high.
Price pivots represent reversals and are the building blocks of trend. A series of lower pivot highs and lower pivot lows is a downtrend, and the pivot highs are connected to form a down trend line. A series of higher pivot lows and higher pivot highs is an uptrend, and the pivot lows are connected to form an up trend line, as shown in Figure 2.
Figure 2: A series of higher pivot lows create an uptrend.
Strategic Uses for Price Pivots
Pivots are also essential for seeing when the trend changes to the opposite direction. A trend reversal is seen by a change in the sequence of pivots. A downtrend will have a series of lower highs and lower lows, and a down trend line is drawn on the pivot highs. Once there is a higher high and higher low, there is presumptive evidence of a trend reversal to the upside (Figure 3).
The strength of the signal is increased when the higher pivot low forms above the down trend line. Aggressive traders can enter at the closing price on the same day the higher low completes the pivot formation. (See also: Retracement or Reversal: Know the Difference.)
Figure 3: Downtrend reversal in Nasdaq futures. The higher pivot low triggers a reversal in the uptrend. This signal is strengthened when the higher pivot low closes above a descending trend line.
Pivots also help in the management of risk. In the example in Figure 3, the stop-loss order is placed under the previous pivot low. Confirmation of the trend reversal from down to up is seen when price makes another higher pivot high and low. If price cannot make a higher high, then a trend reversal has not occurred, and the trader will exit the trade. If price does make a higher high and higher low, then the stop-loss is moved to the next higher pivot low, and the stop is trailed under subsequent pivots as the trend progresses. (See also: Trailing Stop Techniques.)
An uptrend reverses to the downside with the opposite pivot sequence. An uptrend will have a series of higher lows and higher highs, and an up trend line is drawn on the pivot lows. Once there is a lower low and lower high, there is presumptive evidence of a trend reversal to the downside (Figure 4). Again, the strength of the signal is increased when the lower pivot high forms below the uptrend line. Traders can enter at the closing price on the same day the higher low completes the pivot formation. An initial stop is placed at the previous pivot high and trailed in accordance with the trend.
Source: Telecharts, Worden Brothers Inc.
Figure 4: Uptrend reversal in Goldman Sachs. The lower pivot high/low triggers a reversal.
Pivots frame out price, allowing us to see when the trend enters a period of change. Price normally cycles between trend and range conditions. When pivots form a series of variable highs and lows, price enters range consolidation, or a sideways trend. In a range, the pivots are not moving consistently up or down. Price moves back and forth between support and resistance, testing for levels of buying and selling pressure. During these periods of price consolidation, trend lines can be drawn on the boundaries of the pivot highs (resistance line) and lows (support line) to show price patterns. (See also: Price Patterns - Part 1.)
Using Patterns as Confirmation
A rectangle, or channel pattern, appears when both support and resistance lines are horizontal (Figures 3 and 5). A triangle pattern is seen when one or both of the lines are slanted (Figures 4 and 5). Small penetrations of these lines can be faded in the opposite direction. The lines also help identify when range conditions change back into trend. A new pivot high with price that remains above the resistance line suggests a breakout into an uptrend. A new pivot low with price that remains below the support line suggests a breakout into a downtrend.
Source: TDAmeritrade Strategy Desk
Figure 5: Chart patterns
One of the major benefits of using pivots for trade signals is that they are objective price points and can make trading less emotional. Either price has reversed or not, based on the structure of the price bars. Stops are placed according to specific pivot points. There is no need to guess where to put a stop or make predictions on the future direction of price. Pivots show us what is really happening as opposed to what we hope will happen. Traders who understand pivot structure will no longer have to wonder what price is doing: They will know.
The Bottom Line
The ability to read structural pivots provides a major edge in trading. Pivots can be used to increase profits with stocks, mutual funds, exchange-traded funds, currencies and futures. Pivots show the presence of trend and when the trend changes into a reversal, consolidation or a breakout from consolidation. Structural pivots help outline important price patterns and give real-time signals for entry, exit and stop-loss placement.