Using Pivot Points In Forex Trading
Trading requires reference points (support and resistance), which are used to determine when to enter the market, place stops and take profits. However, many beginning traders divert too much attention to technical indicators such as moving average convergence divergence (MACD) and relative strength index (RSI) (to name a few) and fail to identify a point that defines risk. Unknown risk can lead to margin calls, but calculated risk significantly improves the odds of success over the long haul.
One tool that actually provides potential support and resistance and helps minimize risk is the pivot point and its derivatives. In this article, we'll argue why a combination of pivot points and traditional technical tools is far more powerful than technical tools alone and show how this combination can be used effectively in the FX market.
Pivot Points 101
Originally employed by floor traders on equity and futures exchanges, pivot point have proved exceptionally useful in the FX market. In fact, the projected support and resistance generated by pivot points tends to work better in FX (especially with the most liquid pairs) because the large size of the market guards against market manipulation. In essence, the FX market adheres to technical principles such as support and resistance better than less liquid markets.
Pivot points can be calculated for any time frame. That is, the previous day's prices are used to calculate the pivot point for the current trading day.
Pivot Point for Current = High (previous) + Low (previous) + Close (previous)/ 3
The pivot point can then be used to calculate estimated support and resistance for the current trading day.
Resistance 1 = (2 x Pivot Point) – Low (previous period)
Support 1 = (2 x Pivot Point) – High (previous period)
Resistance 2 = (Pivot Point – Support 1) + Resistance 1
Support 2 = Pivot Point – (Resistance 1 – Support 1)
Resistance 3 = (Pivot Point – Support 2) + Resistance 2
Support 3 = Pivot Point – (Resistance 2 – Support 2)
To get a full understanding of how well pivot points can work, compile statistics for the EUR/USD on how distant each high and low has been from each calculated resistance (R1, R2, R3) and support level (S1, S2, S3).
To do the calculation yourself:
- Calculate the pivot points, support levels and resistance levels for x number of days.
- Subtract the support pivot points from the actual low of the day (Low – S1, Low – S2, Low – S3).
- Subtract the resistance pivot points from the actual high of the day (High – R1, High – R2, High – R3).
- Calculate the average for each difference.
The results since the inception of the euro (January 1, 1999, with the first trading day on January 4, 1999):
- The actual low is, on average, 1 pip below Support 1
- The actual high is, on average, 1 pip below Resistance 1
- The actual low is, on average, 53 pips above Support 2
- The actual high is, on average, 53 pips below Resistance 2
- The actual low is, on average, 158 pips above Support 3
- The actual high is, on average, 159 pips below Resistance 3
The statistics indicate that the calculated pivot points of S1 and R1 are a decent gauge for the actual high and low of the trading day.
Going a step farther, we calculated the number of days that the low was lower than each S1, S2 and S3 and the number of days that the high was higher than the each R1, R2 and R3.
The result: For the initial 2,026 trading days since the inception of the euro.
- The actual low has been lower than S1 892 times, or 44% of the time
- The actual high has been higher than R1 853 times, or 42% of the time
- The actual low has been lower than S2 342 times, or 17% of the time
- The actual high has been higher than R2 354 times, or 17% of the time
- The actual low has been lower than S3 63 times, or 3% of the time
- The actual high has been higher than R3 52 times, or 3% of the time
This information is useful to a trader; if you know that the pair slips below S1 44% of the time, you can place a stop below S1 with confidence, understanding that probability is on your side. Additionally, you may want to take profits just below R1 because you know that the high for the day exceeds R1 only 42% of the time. Again, the probabilities are with you.
It is important to understand, however, that these are probabilities and not certainties. On average, the high is 1 pip below R1 and exceeds R1 42% of the time. This neither means that the high will exceed R1 four days out of the next 10, nor that the high is always going to be 1 pip below R1. The power in this information lies in the fact that you can confidently gauge potential support and resistance ahead of time, have reference points to place stops and limits and, most importantly, limit risk while putting yourself in a position to profit.
Using the Information
The pivot point and its derivatives are potential support and resistance. The examples on the next page show a setup using pivot point in conjunction with the popular RSI oscillator.