Pivot Points, the FX Traders Guide

April 05, 2007

Name: John Person

Company: Sponsored by FX Futures.com

Years Trading: 27

Favorite Movie: The Godfather

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This article will describe the pivot point mathematical calculations, how to use multiple time frames for these calculations and the principles behind the rationale behind the psychological impact that drives traders to make decisions around these levels. Each investment vehicle has its own nuances, such as trading session hours, time periods in which volume flows change, contract sizes and decimal point placement. Using foreign currency futures at the CME are more uniformed and have a set closing time so that you can correctly calculate the Pivot Point levels. First, you need to know the foundation of the methodology of Pivot Point analysis; this will then allow you to apply it to the specific markets of interest that you are trading. My goal is to inform you how to:

Predict support and resistance levels for specific time periods.
Understanding how to use pivot points as a moving average component.
Build a trading system based on pivot points.

First let's discuss the power in using pivot analysis. It is an effective tool that can work in all markets that have established ranges, based on significant volume or a large group of collective participants. After all, the current market price equals the collective action of buyers and sellers. Pivot Point analysis is a robust, time tested and best of all, testifiable form of market analysis. This means that you can back test to see the accuracy of this trader's tools predictive analysis. The really unbelievable aspect of Pivots is who uses them. In fact, many traders feel compelled not to learn about them because they seem complicated. I will dispel that myth. Pivot Point Analysis is the best "right side" of the chart indicator as I like to call it, due to its predictive accuracy. In my first book, The Complete Guide to Technical Trading Tactics, I illustrated many trading methods that one can apply using Pivot Point Analysis with Candlestick Patterns, including the power of multiple time frames, or what is know as confluence of various target levels. This article will highlight those techniques as well as explain how to incorporate the Pivot Point as a moving average trading system, and divulge various formulas that are popular today. Pivot Point is a mathematical formula designed to determine the potential range expansion based on a previous time period's data, which includes, the high, the low and the close or settlement price. One reason why I believe in using these variables from a given time period's range is that it reflects all market participants' collective perception of value for that time period. The range, which is the high and low of a given time period, accurately reflects all market participants' exuberant bullishness and or pessimistic bearishness for that trading session. The high and low of a given period is certainly important, as it mirrors human emotional behavior. Also, the high is a reference point for those who bought out of greed thinking they are missing an opportunity. Imagine buying the high for a specific session, you certainly won't forget how much was lost and how the market reacted as it declined from the highs. Therefore you most likely would not buy at or near that level. That is why the high is important to remember. The opposite is true for those who sold the low of a given session out of fear they would lose more by staying in a long trade; they certainly will respect that price point the next time the market trades back at that level too. So the high and low are important reference points of interest. With that said, Pivot Point analysis incorporates the three most important elements, the high, the low and of course the close of a given trading session. The most common formula is:

Pivot Point - high, low, and close added and divided by three. P= (H+L+C)/3
Resistance 2 - Pivot Point number plus the high and minus the low. R2=P+H-L
Resistance 1 -Pivot Point number times to minus the low. R1=(Px2)-L
Support 1 -Pivot Point number times 2 minus the high. S1=(Px2)-H
Support 2 - Pivot Point number minus the high plus the low. S2=P-H+L

Some analysts are adding a third level to their pivot calculations to help target extreme price swings on what has occurred on occasion, such as a price shock resulting from a news event. It seems that the FOREX Currency markets tend to experience a double dose of price shocks as they are exposed to foreign economic developments and US economic developments that pertain to a specific country's currency. This tends to make wide trading ranges. Therefore a third level of projected support and resistance was calculated.

Resistance 3 = H + 2x's (Pivot - Low)
Support 3 = L - 2x's (High - Pivot)

Foreign currency attracts many day and swing traders due to this environment of heightened market volatility. As a result there are those who use Pivot Points in their daily analysis routine. In fact many people track the pivot lines on their charts and include the midpoints between these support and resistance levels. If you added these midpoint numbers to the respective three resistance and three support levels you would end up having thirteen lines across your screens each day. That to me adds little value and in fact causes information overload. That is why I incorporate various time periods in my daily routine such as the weekly and monthly calculations. There is also an added value in identifying a confluence of higher degree time periods which gives a more important and higher probability that price moves may exhaust themselves over a period of time. In addition instead of using a simple moving average based on the close, if you took a moving average of the high, low and close you would have a better weight or measurement of the close as it relates to the specific time period's range. While some traders feel a bullish condition is based on higher highs, higher lows and higher closes than the previous close, I see a better method is to make sure that if the market is truly bullish the close is closer to the high as well. In fact that is a principle of what the stochastics indicator measures. The actual pivot point is also considered the typical price; it is used as a foundation in Bollinger Bands and the Commodity Cannel Index (CCI). So why not use the typical price as a moving average as well?

In the chart above using the CME's June contract of the British Pound, we can see prices in the first pane, with the heavy lines going across the chart showing monthly and weekly pivot support and resistance lines. The thinner lines are just the two daily support and resistance levels. As you can see the low on March 5th was more accurately identified by using the longer term time period pivot points rather than the daily lines as most traders use. This is a very important point and why many short term traders may find using the longer term pivot support and resistance levels more effective especially when using indicators to identify buy and sell triggers. All traders should use the longer term analysis in their trading approach. Then in the middle of the chart we have the stochastics indicator which we discussed in last week's article how to use this indicator to help time market turns. At the bottom of the chart we see the MACD indicator. If you can identify where prices are when an indicator generates a signal, by using longer term pivot point analysis in your trading approach you may find a great way to filter out false signals. For example, the MACD triggers a sell signal on March 5th 2007, the MACD moving average component generates a cross-over signal and the MACD histogram makes a zero line cross. Here is the trouble, the MACD sell signal occurs right at the weekly and monthly pivot point support levels. The stochastics indicator gave a sell signal one day earlier allowing for a profitable entry of over 200 points. The longer term pivot point support levels, and the subsequent confluence of the weekly and monthly that lined up gave additional warning and a targeted profit objective. Here is an excellent and powerful example as to when to exit a position or better yet when NOT to get short. At the very least by using the longer term pivot target levels you can heighten your awareness to a strong support area. It also gave you additional insight as to filter out a sell signal. As we enter April we now see a convergence of Pivot Point resistance levels. The monthly R-1 is 198.68 and the weekly R-2 is 198.20. The high of this move so far was 198.16, just four ticks within the predicted weekly resistance. Considering the fact that the low of 191.77 that occurred on 3-5-07, took 21 trading days to reach 198.15, that is an aggressive 638 point move in a pretty short time frame. That information, combined with the stochastics indicator showing a potential cycle high time period, and the fact even though the MACD indicator is still showing the market in a buy mode, it is warning of a slight bearish divergence in the histogram component.

Here is where we can benefit from pivot point analysis in the next few weeks, we can choose not to take buy signals and in fact if we see further evidence that the bullish momentum is losing steam we can take sell signals. One such method to generate a sell signal is if prices trade back below the moving average of the pivot point on a daily basis. We can go into the principles of moving average signals and the various components of measuring moving averages in another article or if you would like to enhance your education my second book, "Candlestick and Pivot Point Trading Triggers + CD-ROM: Setups for Stock, Forex, and Futures Markets", devotes an entire chapter on the pivot point moving average and the methods described in this article.

About the Author

John Person is the author of three trading books and two trading courses, His first book, The Complete Guide to Technical Analysis for the Futures Markets, was the first ever to introduce traders to a powerful combination of candlesticks and pivot point analysis. His second book took traders to an entirely different level - Candlestick and Pivot Point Trading Triggers + CD-ROM: Setups for Stock, Forex, and Futures Markets, includes a pivot point calculator, instructional videos and exact rules for entries and exits on trades. In his third book, Forex Conquered: High Probability Systems and Strategies for Active Traders, he shares a trading system with the codes for Genesis and Tradestation users. His appears regularly on CNBC and is editor of the Bottom Line Newsletter found on www.nationalfutures.com website.