Trading with pivot points

Pivot points are a versatile technical tool that can be used in a range of trading styles and, when combined with other technical tools, can be used effectively across a range of markets.

A pivot point is the average of the previous period’s high, low and close. As you can define the previous period, pivot points can be used by intra-day traders, day traders, swing traders and as a part of longer-term strategies.

The pivot point can then be used to calculate potential support and resistance for the current period.

Resistance 1 = (2 x pivot point) – previous low

Support 1 = (2 x pivot point) – previous high

Resistance 2 = (pivot point – support 1) + resistance 1

Support 2 = pivot point – (resistance 1 – support 1)

Resistance 2 = (pivot point – support 2) + resistance 2

Support 2 = pivot point – (resistance 2 – support 2)

If we use the daily prices of the EUR/USD forex pair as an example, on August 3 the high was 1.43723, the low was 1.41438 and the close was 1.43432. This would make the pivot point 1.42864 ([1.43723 + 1.41438 + 1.43432]/3).

Consequently, support and resistance levels for August 4 would be:

Resistance 1 = (2 x 1.42864) – 1.41438 = 1.4429

Support 1 = (2 x 1.42864) – 1.43723 = 1.42005

Resistance 2 = (1.42864 – 1.42005) + 1.4429 = 1.45149

Support 2 = 1.42864 – (1.4429 – 1.42005) = 1.40579

Resistance 3 = (1.42864 – 1.40579) + 1.45149 = 1.47434

Support 3 = 1.42864 – (1.45149 – 1.40579) = 1.38294

In actual fact, the August 4 trading range was between 1.43685 and 1.40595, so we can see that these levels don’t hold 100% of the time.

However, between the inception of the euro in 1999 and October 2006, it was found that:

The actual low was lower than Support 1 44% of the time

The actual high was higher than Resistance 1 42% of the time

The actual low/high was lower/higher than Support/Resistance 2 17% of the time

The actual low/high was lower/higher than Support/Resistance 3 3% of the time

Consequently, these levels still provide a decent gauge for trading ranges, with the probability of the currency pair trading within support and resistance levels increasing with each level (so there was a higher probability that trading would occur between Support and Resistance 3 than between Support and Resistance 1).

This allows a trader to place a stop below Support 1 and know that probability is on his side, as the currency pair will only fall below that level 44% of the time. The trader could also place a limit order to automatically close his trade just below Resistance 1, as the high of the day surpasses this level only 42% of the time.

That being said, these are just probabilities, and can vary, especially in times of extreme volatility.

Conclusion

Pivot points can be useful for determining potential support and resistance levels across a range of trading styles – intra-day traders could use 15-minute or 1-hour periods to calculate pivot points, while day-traders could use daily periods, swing traders could use weekly periods and position traders could use monthly periods. As only the time frame changes, the system remains the same for every style.

It is also a good strategy across a range of markets, though the size and liquidity of the forex market makes it particularly useful, as this guards the forex market against market manipulation and results in it holding better to technical principles.

Day trading techniques for new traders

Day trading is when you open and close positions on the same trading day, with trade durations ranging from a few minutes to several hours. Day traders may buy and sell several times in a single day.

One of the benefits of day trading is that you can take advantage of intermittent price dips and spikes, and you won’t need to factor over-night financing costs into your profits.

Choosing trading instruments

As day trading involves making profits in very short time-frames, most day traders choose assets that have high liquidity, and high volatility.

Liquidity means that it is an asset that many people trade – if you were trading forex, the EUR/USD pair would be more liquid than the GBP/HUF pair as more people trade it. Very liquid assets have lower bid/offer spreads, which will increase your profits.

Volatility is the measure of the range in which an asset moves over a period – assets that are very volatile have a greater range of movement. As traders profit on the price movements of financial instruments, the greater the movement the greater the profit (or loss).

Entry strategies

So now that you’ve chosen a liquid and volatile asset to trade, when do you open your trade? Depending on whether you want to be a fundamental or technical trader, this can be a combination of a number of factors:

Fundamentals include economic, political and social events, and the impact they will have on an asset price. If you want to trade on Commonwealth Bank shares and you know that the CEO is going to be holding a press conference, this might be a good time to enter a trade. The expected announcements of the press conference would affect whether you trade long (buy in the hope that the share price will go up) or short (sell in the hope that the share price will go down).

Technical trading involves examining charts arguing that, as patterns repeat themselves; past patterns can indicate future price movements. Some simple technical tools to use include support and resistance, swing points, and indicators.

Support and resistance are the points at which an asset price will change directions – support being the lowest point it will reach before going up and resistance being the highest point it will reach before turning down. If you mark support and resistance lines on your charts, this can be a good indicator for when to enter a trade, and whether to go long or short.

Swing points are useful when looking at assets charted using candlesticks – either the first candle hits a low, the second hits a lower-low, and the third hits a higher low; or the first candle hits a high, the second hits a higher-high, and the third hits a lower high. This is an indication that the asset price will likely reverse.

Slightly more advanced is plotting the price of an asset against an indicator, or another statistical measure. One example of this is having one chart that measures momentum (the rate of change of an asset price) against the chart of the asset prices. If there is a divergence, when the asset price makes a new high or low and the momentum does not, this could be a warning of a change in trend direction.

Exit strategies

Now you have entered your trade using fundamental or technical analysis – when to exit?

Most exit strategies fall into the following categories – loss limits, profit targets, and timed exits.

A loss limit is the amount you are willing to lose on a single trade, with the general rule being never to risk more than 2% of your capital. Stop loss orders enable you to set automatic closing levels on your trade, which takes the emotion out of trading, and also enables you to limit your losses even if you aren’t able to constantly monitor your open positions.

A good stop to use is a trailing stop – like stop losses, a trailing stop is when you set an automatic closing level on your trade. However, a trailing stop will automatically follow the market when it moves in your favour, meaning that you will protect your profits if the market changes directions again.

Profit targets can also be set automatically at the time you open the trade – you simply set the level at which you want your trade to exit if the market moves in your favour.

A timed exit is determining a time at which you want your trade to close – this could be timed with personal restrictions, economic or political news, or the end of different trading sessions.

Performance evaluation

It is essential for beginning traders to monitor and evaluate their trading performance. A good evaluation should cover your trading profit and loss, your trading performance (the way your trades behave, including the amount of profit made, the percentage of profits and losses, whether your trades were short or long, etc.), and your trading process (your trading preparation, your entry and exit rules, your risk management and your trading evaluation).

Once you have determined which aspects of your process will help your trading and which performance criteria you want to measure, you need to decide how to measure these elements. Tools could include performance monitoring packages available with your trading software; or spreadsheets recording the profit, loss, volume and volatility of your trades; or a journal recording your trading decisions.

As this article discusses day trading, it would be valuable for traders to evaluate their progress on a daily, weekly and monthly basis.

Conclusion

These considerations should help a beginning day trader. Remember to automate entries and exits wherever possible, as this will help you remain level headed and make informed decisions, and start with small investments as you test your trading system. Then keep good records to monitor how your trading system performs!