How to Trade Using Pivot Points?

What Are Pivot Points?

Pivot Points are important support and resistance levels derived from the high, low, and closing prices of prior trade sessions. They serve as technical analysis indicators utilised to predict potential trades and identify entry and exit points in the actual or upcoming session.

Pivot Points calculations are based on the prior day's trade range. The basic pivot point (PP) is the central pivot from which other pivot levels are derived. Support and resistance levels calculations are made utilising specific formulas. Pivot Points give traders levels to analyse the market and determine potential areas of price reversal or continuation.

How Important Are Pivot Points?

Here are the crucial points regarding the importance of pivot points:

Trend Identification: Pivot points aid traders in determining the current market trend. If the price is trading upper the pivot point, it suggests bullish sentiment, showing potential opportunities for long positions. And if the price is trading under the pivot point, it suggests bearish sentiment, showing possible opportunities for short positions.

Support and Resistance Levels: Pivot points give additional support and resistance levels beyond the pivot point itself. These level calculations are based on the pivot point formula and aid traders identify price levels where the market could have support or resistance. Traders utilise these levels to make decisions on entry, Stop Loss, and Take Profit points.

Entry and Exit Points: Day traders frequently utilise pivot points to identify possible entry and exit points for their trades. When the price approaches a support level near the pivot point and bounces back, it can be seen as a buying opportunity. And when the price approaches a resistance level near the pivot point and reverses, it can be considered to be a selling opportunity. This strategy is known as pivot point bounces. Also, when the price breaks through the pivot point, traders may consider entering trades in the breakout direction, known as pivot point breakout strategy.

Short-Term Trading: Pivot points are particularly helpful for day traders who operate within shorter time frames. Unlike other technical indicators that may utilise longer time frames, pivot points concentrate on info from a single day, making them relevant for intraday trade strategies.

Accuracy: Pivot points are seen as highly accurate indicators in the market. They provide a concise framework for understanding the price action and predicting potential market movements based on the prior day's trade activity. Many day traders rely on pivot points due to their perceived accuracy in identifying trade entry and exit points.

It's essential to note that while pivot points can be a valuable tool in trade strategies, they should not be used in isolation. Traders frequently combine pivot points with other technical indicators, like moving averages, oscillators, and volume analysis, to obtain a more comprehensive market understanding and make well-informed trade decisions.

What Are the Limitations of Pivot Points?

Here are some of the limitations of pivot points:

Reliance on historical data: Pivot points heavily rely on historical info and may not capture the most current market conditions or changes in investor sentiment. Traders should consider combining pivot points with other technical indicators or fundamental analysis to gain a more comprehensive market understanding.

Lack of adaptability: Pivot points are primarily designed for short-term trading and are recalculated daily. This means that they may not be as effective in capturing longer-term trends or providing reliable signals for medium to long-term investment strategies. Traders with different time horizons should utilise pivot points together with other indicators suitable for their preferred trade style.

Market noise: Like any technical indicator, pivot points are not immune to noise of the market or sudden fluctuations of the price. In highly volatile markets or during news releases, prices can quickly move beyond the projected support and resistance levels provided by pivot points. Traders should exercise caution and consider using additional risk management tools to account for unexpected market movements.

Lack of universal application: Pivot points are primarily used in equities, commodities, and forex markets. While they can be applied to other financial instruments, their effectiveness may vary. Different markets and securities may have unique characteristics and behaviour patterns, which could limit the applicability and accuracy of pivot points. Traders should consider testing pivot points on specific instruments to assess their effectiveness.

Overuse and self-fulfilling prophecy: Pivot points have gained popularity among traders, and as a result, they are widely followed and watched. This widespread use can sometimes lead to self-fulfilling prophecies, where traders' actions based on pivot points actually cause price movements that align with the projected support and resistance levels. This effect can lead to increased market volatility and make pivot points less reliable as more traders base their decisions on them.

Remember, while pivot points can be a useful tool in a trader's toolbox, it is important to consider them as part of a comprehensive trading strategy and not rely solely on them for making trading decisions. Traders should analyse multiple indicators, market trends, and fundamental factors to gain a well-rounded understanding of the market before executing trades.

How to Calculate Pivot Points?

Here are the rules for pivot point calculations:

Calculate the Pivot Point (PP): The pivot point is the average of the high, low, and closing prices from the previous trading day. The formula for calculating the pivot point is as follows: 

Pivot Point (PP) = (Previous High + Previous Low + Previous Close) / 3

Calculate Support and Resistance Levels: 

Support 1 (S1) = (Pivot Point * 2) - Previous High; 

Support 2 (S2) = Pivot Point - (Previous High - Previous Low); 

Resistance 1 (R1) = (Pivot Point * 2) - Previous Low; 

Resistance 2 (R2) = Pivot Point + (Previous High - Previous Low)

Alternative methods: There are variations of the five-point system that include the opening price in the calculations. These variations may provide additional levels of support and resistance.

What Are Pivot Point Strategies?

Traders can consider the following pivot point trading strategies:

a) Pivot Breakout: Traders watch for a break above or below the pivot point level as a potential entry signal.

b) Pivot Bounce: Traders anticipate price reversals when the price reaches a pivot point level, aiming to enter trades in the opposite direction.

c) Pivot Retracement: Traders look for price retracements towards pivot point levels and use them as potential support or resistance levels to enter trades.

Bottom Line and Key Takeaways

Pivot Points provide traders with valuable support and resistance levels to make informed trading decisions. They can be used to define trading ranges, identify potential reversals, and determine overall market trends. However, it's important to consider pivot points in conjunction with other technical indicators and market analysis tools for a comprehensive trading strategy.