What is Pivot Point

Key takeaways

1. Fundamental tool in technical analysis: Pivot points are a crucial tool in technical analysis, widely used by traders and investors to identify potential price levels in financial markets.
2. Significance in trading: Pivot points serve as essential reference points for making trading decisions, indicating potential support and resistance levels and guiding entry and exit points for trades.
3. Calculation and formulas: The calculation of pivot points involves straightforward formulas, including the pivot point itself along with support and resistance levels derived from previous session's high, low, and close prices.
4. Usage for intraday trading: Pivot points are particularly useful for intraday trading, providing insights into short-term price movements, trend reversals, price targets, and intraday volatility assessment.
5. Limitations and considerations: While pivot points offer valuable insights, traders should be aware of their limitations, including their reliance on past price data, potential ineffectiveness in low liquidity markets or during extreme volatility, and the need for caution when combining them with other technical indicators.

Pivot points are a fundamental tool in technical analysis, widely used by traders and investors to determine potential price levels in financial markets. They serve as critical reference points for making trading decisions, providing insights into potential support and resistance levels. In this article, we will explore the concept of pivot points, the formulas used to calculate them, their significance in trading, and how to utilise them effectively.

​What is pivot points?

A pivot point is a technical analysis indicator used by traders and investors to determine potential price levels in financial markets. They serve as critical reference points for making trading decisions, providing insights into potential support and resistance levels. In this article, we will explore the concept of pivot points, the formulas used to calculate them, their significance in trading, and how to utilise them effectively.

The formulas for pivot points

The Pivot points formula is relatively straightforward and includes several support and resistance levels:

• Pivot Point (PP) = (High + Low + Close) / 3
• First Resistance (R1) = (2 x PP) - Low
• First Support (S1) = (2 x PP) - High
• Second Resistance (R2) = PP + (High - Low)
• Second Support (S2) = PP - (High - Low)
• Third Resistance (R3) = High + 2 x (PP - Low)
• Third Support (S3) = Low - 2 x (High - PP)

How to calculate pivot points

Now that we've covered the technique of calculating the pivot points, let's walk through a step-by-step guide on how to calculate them using the standard pivot points method:

Step 1: Gather the necessary data

• High: The highest price during the previous trading session.
• Low: The lowest price during the previous trading session.
• Close: The closing price of the previous trading session.

Step 2: Calculate the pivot point (PP)

• PP = (High + Low + Close) / 3

Step 3: Calculate the first resistance (R1) and first support (S1)

• R1 = (2 x PP) - Low
• S1 = (2 x PP) - High

Step 4: Calculate the second resistance (R2) and second support (S2)

• R2 = PP + (High - Low)
• S2 = PP - (High - Low)

Step 5: Calculate the third resistance (R3) and third support (S3)

• R3 = High + 2 x (PP - Low)
• S3 = Low - 2 x (High - PP)

Let's delve into the significance of pivot points and how to use them effectively in trading.

What do pivot points tell you?

Pivot points are essential for traders as they offer valuable insights into potential price movements. Here's what pivot points can tell you:

1. Support and resistance levels: Pivot points identify key levels where the price is likely to encounter support (S1, S2, S3) or resistance (R1, R2, R3).
2. Trend reversal points: When the price approaches a pivot point, it may signal a potential trend reversal. Traders often look for confirmation before making decisions.
3. Price targets: Pivot points can be used to set price targets for trades. For example, if a trader goes long at the pivot point (PP), they might aim to take profits at the first resistance (R1) level.
4. Intraday volatility: Pivot points provide a framework to assess intraday price volatility. Wide price spreads between support and resistance levels may indicate high volatility.

How to use pivot points for intraday trading?

Employing pivot points for intraday trading involves two main strategies: pivot point bounce and pivot point breakout.

1. Pivot point bounce:

This strategy revolves around using the pivot point as a key indicator for asset price movements. Traders assess whether the price rebounds off the pivot point or breaks through it to determine their trading decisions. 

• Buying: Traders look to enter a long position when the price touches the pivot point from above and reverses direction. They anticipate a bounce off the pivot point as a signal to buy the asset.
• Selling: Conversely, traders aim to sell when the price tests the pivot point from below and bounces off it. This indicates a potential downward movement, prompting traders to sell the asset to avoid losses.
• Utilising support and resistance: Traders capitalise on the support and resistance levels identified by pivot points. Buying just before the price touches the support level maximises profit potential, while selling before reaching the resistance line mitigates potential losses.

2. Pivot point breakout:

This strategy involves anticipating price movements beyond the pivot points, signaling a continuation of the trend in either direction.

• Bullish breakout: Traders anticipate upward price momentum when the price surpasses a pivot point, typically opening long positions to capitalise on the positive market sentiment.
• Bearish breakout: Conversely, if the price breaks below the support line, traders initiate short positions, anticipating a downward trend as indicated by the breakout.
• Risk management: Traders employ stop-loss or stop-limit orders slightly above or below the pivot points to protect against sudden price fluctuations. This ensures their interests are safeguarded during volatile market conditions.

Why do day traders prefer pivot points?

• Accuracy: Pivot points are renowned for their high accuracy in predicting the day's likely price action based on previous trading data, allowing day traders to align with the market trend effectively.
• Short time frames: Pivot points are particularly well-suited for short-term trading due to their reliance on data from a single day of pivot trading.
• Ease of use: The pivot point indicator is user-friendly, reducing the need for manual calculations. Trading platforms often automatically calculate support and resistance levels, enabling day traders to focus on strategy development for the day.

Uses of pivot points

Pivot points serve multiple important purposes in trading:

1. Pivot points are valuable tools for day traders to gauge market trends. By analysing the direction of price movement relative to these points, traders can discern whether the market is likely to be bullish (favouring buyers) or bearish (favouring sellers). This helps traders align their strategies with the prevailing trend.
2. Pivot points are not only trend indicators but also aid traders in timing their market entries and exits. For example, traders can use pivot levels to decide where to place stop-loss orders, which limit potential losses in case of adverse market movements. This risk management strategy is especially important for safeguarding capital and maintaining trading discipline. Pivot points thus provide a structured approach to making informed trading decisions.

Pivot points vs. Fibonacci retracements

While both pivot points and Fibonacci retracements are valuable tools for technical analysis, they serve different purposes:

• Pivot points: Primarily used for identifying support and resistance levels and making intraday trading decisions.
• Fibonacci retracements: Utilised to identify potential levels of price retracement within a trend, aiding in trend-following strategies.

Limitations of pivot points

Despite their usefulness, pivot points have limitations that traders should be aware of:

1. Lack of predictive power: Pivot points are based on past price data and may not always accurately predict future price movements. They are best used in conjunction with other technical analysis tools.
2. Market dynamics: Pivot points may not work effectively in markets with low liquidity or during news events that cause extreme price volatility. In such conditions, sudden price gaps can render pivot levels less reliable.
3. Overuse: Due to their popularity, pivot points can become self-fulfilling prophecies. When too many traders rely on the same levels, it can lead to crowded trades and potential reversals.
4. Not suitable for long-term trading: Pivot points are primarily designed for intraday and short-term trading. They may not provide meaningful insights for long-term investors or swing traders who focus on larger price trends.
5. Formula variations: Different traders may use various pivot point formulas, leading to variations in the support and resistance levels they identify. It's important to understand which formula is being used to avoid confusion.

Conclusion

Pivot points are a valuable tool for traders seeking to identify potential support and resistance levels, make intraday trading decisions, and manage risk effectively. While they are not without limitations, when used in conjunction with other technical analysis tools, pivot points can provide valuable insights into market dynamics.

Traders should keep in mind that pivot points are not a guaranteed method for predicting price movements. They work best when combined with other indicators, such as moving averages, trendlines, and oscillators, to confirm trading signals.

In summary, pivot points are a versatile tool that can be adapted to various trading strategies. Whether you are a day trader looking for short-term opportunities or a swing trader seeking to time entries and exits, pivot points can enhance your technical analysis toolkit. However, it is crucial to use them with caution, considering the market conditions, and to always practice sound risk management. As with any trading strategy, continuous learning, and adaptation to changing market dynamics are key to success.