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Although especially popular with floor traders due to their computational simplicity, pivot points also provide a useful trading signal methodology for forex traders. One of the main advantages of using pivot point analysis comes from the fact that it often has some useful predictive value, while most other technical indicators tend to lag behind the market.
The pivot point itself is determined by computing the simple average of the previous day’s high, low and closing rates. Three sets of theoretical support and resistance levels can then readily be derived from that information. The section below covers the pivot point, support and resistance level calculation in greater detail.
Calculating Pivot Points
Calculating each of the pivot point levels just requires the High, Low and Close prices for the previous period. The equation looks like this:
You then calculate theoretical support and resistance levels around this pivot point with the following formulas:
First Levels:
Second levels:
Third Levels:
Then you would plot horizontal lines at each of these seven levels on a chart of the exchange rate as it evolves over time.
Trading Pivot Points
The most important pivot point levels used when trading are the R1 and S1 levels, in addition to the key central pivot point. The other support and resistance points generally seem best used for profit-taking.
When using pivot points in practice, forex traders would first observe the level of the market at the open. If the market opens above the central pivot, then the sentiment is bullish and long trades will be preferred. Conversely, an open below the pivot point indicates a bearish outlook, with a resulting preference for establishing short positions.
Pivot Point Trading Signals
Forex traders will generally watch for a break of the R1 or S1 levels to signal the direction in which to take a position. They might also confirm such a break using another indicator like a set of moving averages.
In terms of the actual trade signals used when trading pivot points, if R1 breaks then a pivot point trader would tend to go long, but if S1breaks they would instead prefer to short the market. Sell stops on longs would usually be placed under R1, while buy stops on shorts would be entered above S1.
When the market eventually goes up to R2 or R3 or down to S2 or S3, it will already tend to be overbought or oversold respectively. As a result, the R2, R3, S2, S3 levels are usually used as exit points for profit taking, instead of as additional entry points.
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