Pivot Points, the FX trader’s Best Guide

April 13, 2007

Name: John Person

Company: Sponsored by FX Futures.com

Years Trading: 27

Favorite Movie: The Godfather

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This article is a follow up from last week's edition that will show you the results of the price action in the British Pound and how prices reacted at the selected pivot point target levels. Hopefully you will learn how effective the longer term pivot point predicted support and resistance levels are and how you can use them in your market analysis and more importantly in your trading decisions. Pivot points, if understood correctly, can be a very powerful analytical tool. As today's article and chart will show, day traders, swing traders and longer term position traders would have all benefited from just two time periods, the weekly and monthly calculations.

If you recall we talked about how to use multiple time frames for these calculations and the principles behind the rationale 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.

Pivot point analysis 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 tool's predictive analysis.

As a quick review, Pivot Points are based on 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 participant's 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 participant's 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

Foreign Currency trading 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 prices moves may exhaust themselves over a period of time.

In the chart below using the CME's June contract of the British Pound, we can see prices with the heavy lines going across the chart showing monthly and weekly pivot support and resistance lines.

More times than not 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. I believe all traders should use the longer term analysis in their trading approach.

As we covered in the article released on April 5th, we talked about a convergence of Pivot Point resistance levels. The high on April 3rd was the first test of the projected resistance levels. The market abruptly sold off right down to the weekly support target. That level held the market. As the Dollar broke the British Pound resumed the longer term up-trend. But what stopped the market in Friday's trade was the overhead confluence of resistance from the monthly and weekly pivot resistance levels. As a trader if I can see where there is hidden resistance from a longer term perspective I can set my profit objectives or better yet make a decision not to buy a breakout when prices are initially testing a longer term resistance. I wanted to review this concept because as you can see from the chart below prices touched the projected monthly and weekly pivot resistance levels and subsequently sold off. Notice that from the week before we touched the weekly pivot resistance and then traded lower right down to the weekly pivot support.

We will continue with the teachings of pivot analysis in the weeks to come and spend time on a variety of parameter settings you can use to incorporate pivot points as a moving average concept. This concept will also help identify if the market trend is bullish, bearish or neutral. That way it will help illuminate the potential direction of the market and then you can filter out which target support and resistance numbers to use. If you would like to enhance your education my 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.