A common problem in trading is figuring out which area on the chart the market pays particular attention to.
And this can be frustrating for new traders or even slightly experienced traders because sometimes we are subject to our own biases in interpreting price data.
You may outline the key levels on your chart differently than others, so when you trade them, it doesn't really produce the results you expect.
A solution to this is to use pivot points.
Pivot points are mathematically calculated support and resistance levels based on the previous period's price metrics.
This makes the levels it creates uniform across platforms.
And in this article, we'll explain what pivot points are and how it works.
You'll also learn three pivot point trading strategies that you can add to your trading repertoire right away.
How do Pivot Points work?
As mentioned, Pivot points use a calculation of the previous period’s price metrics (namely the high, low, and close) to generate layers of support and resistance on the chart.
Usually, that previous period is the prior day, but it can also be weekly or even monthly prices.
Pivot points can also have as many as seven levels although other charting applications can generate up to eleven.
The main pivot point, which is the middle line, is the average of those price metrics, and the other levels extending above and below it are derived from it.
How are Pivot Points calculated?
Here is the formula for calculating the main pivot point:
Pivot Point = (High + Low + Close) / 3.
Then, the first layer that moves away from the central pivot point follows this calculation:
R1 = 2 × Pivot Point − Low
S1 = 2 × Pivot Point − High
The second layer of pivot points has the following formula:
R2 = Pivot Point + (Hight − Low)
S2 = Pivot Point − (High − Low)
And the third level pivot points are calculated like this:
R3 = High + 2 × (Pivot Point − Low) = R1 + (High − Low)
S3 = Low – 2 × (High − Pivot Point) = S1 − (High − Low)
What are pivot points used for?
The standard way traders use pivot points is to spot critical turning points in the chart.
It sets boundaries for where the price can eventually break or bounce off on, but there are also other uses for pivot points, and it includes the following:
In terms of markets, pivot points can be applied to different assets like stocks and commodities. There are also pivot point strategies for the foreign exchange market that work this technical tool effectively.
Three Pivot Point Strategies
Here are some of the best ways to trade pivot points:
1. Pure Price action
One way you can use pivot points is to build a system that is purely price action.
This means that you'll be trading solely on the merit of how the price is trading inside the range of the pivot levels, or in other words, you'll be trading indicator-free.
This hinges on the fact the pivot points are a good gauge of momentum, as we've touched on earlier.
It's also similar to the concept of simple support and resistance trading but, again, carries more weight since a lot more traders keep an eye on it.
One way for you to go about implementing price action on pivot levels is to set specific rules.
For example, you consider a break as a full-candle close above or below a pivot point.
And you consider a partial close as a bounce.
You can also define what your risk and reward are going to be based on where the price is relative to the pivot levels.
Let's say the break above R1 is too far off, so instead of using the main pivot point level as stop-loss, it can be a few pips below R1.
Once you've established your rules, you'll be able to frame how you are going to trade pivot points using price action. A clear set of rules will help you build a workable system.
2. Use an oscillator
Oscillators can serve as a gauge of whether an asset's price might be presently overbought or oversold.
Oscillators create two bands that represent those two extreme conditions.
And its reading or the value it shows fluctuates between those two levels.
For example, if you use the RSI, you'll notice that it uses a scale of 0 to 100.
There are also two horizontal lines marking 30 and 70.
30 is the oversold level while 70 is overbought.
How does it help you?
By knowing what the oscillator reading is, it can support the way you trade pivot points.
For instance, if the oscillator signals an extreme condition, you can use this as a way to confirm your trade entry or be an indication for you to close a particular position.
Take a look at the RSI reading when the price was at the R1 level. You can see that it's overbought.
Now, when the AUDUSD almost made a full-body candle close below that pivot point, the RSI also moved away from the overbought region (>70).
You can build an entire system based on how these two technical tools work together but remember always to backtest your strategy to get a good gauge of its performance.
3. With candlesticks
Finally, the last method is to pair pivot points with candlestick analysis.
Candlesticks provide a way to identify an opportunity to exit or enter a trade based on specific patterns.
Each pattern has a corresponding indication, and familiarity about what they signify puts you in a better position to trade them effectively.
How do you use them with pivot points?
If you are aware of what a pattern indicates when they appear on a particular pivot point, you'd be able to gauge what could likely happen and place the appropriate trade.
Take a look at the same currency pair back on November 18:
AUDUSD couldn't close below the main pivot point, and a bullish engulfing pattern appeared.
If you're trading solely based on these two tools, a buy position would be in order.
And, as you can see, the result turned out well.
Following the price action trading concept, the next pivot point level is the target.
And in the case of this long trade, it's the R1 level, the next pivot point higher.
An entry like this would have a stop-loss set at a few pips below the entry since the main pivot point offered a great support level.
Do I have to study all candlestick patterns?
Well, the simple answer is that it would help you a lot if you know what most candlestick patterns indicate, but remember that patterns can appear everywhere on that chart.
What's more important is if it appears on a significant support or resistance area, and that's what the pivot points offer you.
If you're starting to learn candlesticks analysis, you can read this article, so you have an idea about some of the most common patterns.