I think the most important fact, yes I said fact, regarding pivots points is they are a prediction of future support and resistance levels. The key word in the previous sentence is “prediction” and traders should keep that in mind when trading pivot point systems. I have always been conflicted as to why pivot points (PP) become important throughout the course of the day. Most traders begin their day by plotting pivot points onto their chart. With so many people using similar formulas to plot PP it is little surprise that the market stops at the calculated support and resistance levels. Do the support levels and resistance levels occur because everyone is using a similar system or are they part of the natural function of the market?
It doesn’t matter.
As a trader I am only interested in what the market does, not why it exhibits certain tendencies. I realize that is a bit of an obtuse answer, but it is one I have learned to live with comfortably. Of course, it is often discussed among traders and each day trader has his opinion, but to trade the markets it is not necessarily important why this phenomena occurs.
On the other hand, some days the market pays absolutely no attention to pivot points and goes along its merry way without stopping at any particular point on the chart. More often than not, though, the market will stop at the pivot points, or pause , or reverse right at the plotted lines. My point is a simple one; pivots are very useful, except when they are not useful. Whether the market will adhere to the predicted support and resistance is something that you must glean from watching the price action for a bit. I typically don’t initiate my first trade of the day based on pivot points.
The formula for calculating the days support, resistance, and pivot point is as follows:
R2 = P + (H – L) = P + (R1 – S1)
R1 = (P x 2) – L
P = (H + L + C) / 3
S1 = (P x 2) – H
S2 = P – (H – L) = P – (R1 – S1)
As you might have surmised, the formula plots five lines on your trading chart. These lines are commonly referred to as S1, S2, PP, R1, and R2. S1 and R1 are the first lines of potential support/resistance on your chart. The pivot point is the primary line of support and/or resistance.
Most traders have their own set-up to trade pivots, and I have three that are favorites of mine. One is a break out through a resistance/support level.
Break outs often time occur when the market is in a consolidating mode and forms a horizontal channel, with the price banging off the top and bottom of the channel, especially if the channel is on a support/resistance line, as is often the case.. After this price action continues for two, maybe three cycles, I will set a sell a point below the channel and a buy a point above the channel. (I am referring to the ES contract here) Generally the price action will break out of the channel and continue in the direction of the break out and you pick up the trade as it blasts through the channel parameters. This is a pretty good strategy and can be very profitable.
Breakdowns are also a great way to use your pivots. This trade is especially good if the market has been hitting a support/resistance line and stopping. As the price action approaches the support/resistance line, I will set a buy one point below the line in hopes of picking up the trade as it pierces the line. This trade can be a bit dodgy, especially if the market has been bouncing off the lines all day because the earlier bounces were usually followed a move in the other direction. Your hope is that the move does not go through the line a bit (as it often does), pick up your trade and change directions. Again, here you can set your order lower, maybe 1.5 points below the line if you are uncomfortable.
Finally, you trade the pullbacks from R and S. Let’s say the market pierces S1 and heads straight to S2 and stops and reverses. Often times the change in direction will go straight to S1 again, retracing it’s move down in the opposite direction. Once it reaches S1 I will set a trade 1 point below S1. More often than not, the trade will hit S1 and reverse field to the short side, and if it continues upward you stayed out of the trade by virtue of setting your sell 1 point below S1. This probably my favorite pivot point trade, and comes with a higher degree of safety than most. Of course, no specific trade works every time. If I am stopped out twice on a pivot point trade, I forget pivot points for the rest of the day.
In summary, we learned that pivot points are predictors of future activity. Further, as predictors they may or may not be effective on a given day of trading. Your power of observation is key to understanding the effectiveness of a pivot point every trading day. We reviewed three basic trades that I use; the breakout, breakdown and pullback. If you learn to combine your trades with an oscillator or a tick chart, you will develop and even higher degree of activity in your trading. Remember to check yourself when trading pivot points, never trade without stop-loss orders in place.