Predicting Reversals With Pivot Points

WHAT ARE PIVOT POINTS?
A pivot point is simply a level at which the current market direction for the day changes. Their use originated with floor traders out of sheer necessity — traders were far too busy to spend time calculating numbers during the trading day. Instead, they would start the trading day with a prepared set of price levels that they had calculated the night before.

In contrast, pivot points have a simple formula that can be adjusted as necessary during the trading day. While intraday in nature, pivot points can be calculated for intraday, end of day, end of week, or even month-long time frames. Not surprisingly, this powerful tool became popular with retail investors as well, mainly due to their predictive nature.

By using the price information of the previous day's range, you can potentially figure out the turning points for the present day's trading. You can say then that pivot points serve as a window of sorts on the next day's price level.

There is one caveat when it comes to pivot points: News of any kind that can potentially move the market (or whatever you are watching) will usually nullify the pivot point numbers, so be prepared to recalculate them as necessary.

CALCULATING PIVOT POINTS
This is the actual mathematical formula used to calculate pivot points. (The H stands for High, C for close, and L for Low.)

PP — Pivot Point = (H+L+C)/3
R1 — First Resistance Level = (2*PP)­ L
S1 — First Support Level = (2*PP)­ H
R2 — Second Resistance Level = P+(R1-S1)
S2 — Second Support Level = P ­ (R1 ­ S1)

As is fairly obvious, the calculations are rather simple. You gather the high, low, and close for the day's trading (or for whatever length of time) of what you are watching.

In the case of a market like the foreign exchange that is really 24 hours, these pivot points can still be used. It is usually understood that the end of the trading day for the foreign exchange market is 4 pm, but I have seen forex brokers who count the end of the day at 5 pm. Check with your forex broker, and once you have the-end-of-day times, you will be able to calculate the forex market as well. Not everyone who uses pivot points with the forex market uses the above-mentioned times as their end of day. Instead, they use a set time each day, say midnight or 2 pm, and they calculate the open and close between their own defined 24-hour period. Forex allows you to set up your own 24-hour period that you feel most comfortable with.

PRACTICING PIVOT POINTS
After you have made these calculations, you will have a set of five numbers. The three most important numbers are the pivot point number (PP), first resistance (R1), and first support level (S1). When there are not many new buyers or sellers, the floor traders or market makers use the pivot point to adjust their bids and offers. Pivot points are short-term indicators, usually only useful for the day. That said, you can generally make an assumption using pivot points. For example, if the pivot point price is broken to the upside, you can assume the market is bullish and the reverse if the pivot point is broken to the downside.

Of course, just breaking the pivot point in any one direction is not enough to signal a buy or sell. There are zones of support and resistance. Those numbers that have already been calculated using the formula provided in this article will be placed above or below the pivot point number. Generally speaking, breaking through either of these numbers will be followed by new buyers or sellers to enter the market.

The idea is to look for breaks in the pivot point number, as well as a break of either R1 or S1. When the market reaches R2 (second resistance) or S2 (second support), it is usually viewed as either overbought or oversold and these levels should be used to make your exit out of the market. When the prices move through any of the points already discussed with increased volume, it is a likely sign that the market will continue the current trend. Following that same thought, if prices touch the pivot point but cannot move through, then that is most likely a reverse of the current trend.

As mentioned, you can use pivot points as a guide for the next day's numbers. The use of pivot points with other indicators that you like can combine to give you a good idea of where the markets will be trading the next day. If you like charts, there are many free charting programs on the Internet that will allow you to draw lines. Find one you like and draw the lines that correspond to the pivot point number as well as R1, R2, S1, and S2. This will give you a visual of the price points and the direction of the market.

But why calculate these numbers yourself when you don't have to? Due to their popularity, there are now pivot point calculators available all over the Internet. A search for "pivot point calculators" will yield numerous results that are web-based or ready for download onto your computer. Try a few out and use the one you feel most comfortable with. The best part of using a web-based calculator is that there will be no mistakes. These calculators also yield very quick results if you need to recalculate the pivot points.

As with any indicator, pivot points by themselves should not be looked at as an answer to your trading questions. Instead, think of pivot points as a new weapon in your trading arsenal. Use them to narrow down and help predict the next day's trading range, and to get an idea of entry/exit points as well as an early indicator of the day's trend. Their popularity is a clear sign of their ease of use and their usefulness to traders.

John Devcic is a market historian and freelance writer. He may be reached at glatko@aol.com.

SUGGESTED READING
Devcic, John [2005]. "Is It Time To Clean Up Your Portfolio?" Working-Money.com, May 18.
___________ [2005]. "Forex At A Glance," Working-Money.com, March 29.
____________ [2004]. "Chart Reading Basics," Working-Money.com, May 5.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.