PIVOT POINT ANALYSIS

PIVOT POINT ANALYSIS
This is the best “right side” of the chart indicator, as I like to call it, due to
its predictive accuracy. Pivot points are based on a mathematical formula
originally developed by Henry Wheeler Chase in the 1930s. Chester W. Keltner
used part of the formula to develop the Keltner Bands as described in his
book, How to Make Money in Commodities (Keltner Statistical Service, 1960).
However, it was really Larry Williams who was credited with repopularizing
the analysis in his book How I Made One Million Dollars . . . Last
Year . . . Trading Commodities (Windsor Books, 1979). Don Lambert, the
creator of the Commodity Channel Indicator (CCI) uses the pivot point formula
that makes the CCI work.
In my first book, A Complete Guide to Technical Trading Tactics
(Wiley, 2004), I illustrated many trading methods that one can apply using
pivot point analysis combined with candlestick patterns, including the advantage
of trading using multiple time frames, or what is know as a confluence
of various target levels based on different time periods. This chapter
will highlight those techniques as well as explain how to incorporate the
pivot point as a moving average trading system and how to filter out and
narrow the field of the respective support and resistance numbers and will
divulge various formulas that are popular today.
As I said, pivot points are a mathematical formula designed to determine
the next time period’s range based on the previous time period’s data,
which includes, the high, the low, and the close or settlement price. One
reason why I believe in using these variables from a given time period’s
range is that it reflects all market participants’ collective perception of
value for that time period. The range, which is the high and the low of a
given time period, accurately reflects all market participants’ exuberant
bullishness and pessimistic bearishness for that trading session. The high
and the low of a given period are certainly important, as they mirror human
emotional behavior. Also, the high is a reference point for those who
bought out of greed, thinking that they were missing an opportunity. They
certainly won’t forget how much they lost and how the market reacted as it
declined from that level.
The opposite is true for those who sold the low of a given session out
of fear they would lose more by staying in a long trade; they certainly will
respect that price the next time the market trades back at that level, too. So
the high and the low are important reference points. With that said, the
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pivot point calculations incorporate the three most important elements of
the previous time period: the high (H), the low (L), and, of course, the close
(C) of a given trading session. First, let me give you the actual mathematical
calculations, and then I will go over what each level represents.
• Pivot point—the sum of the high, the low, and the close divided by
three.
P = (H + L + C)/3
• Resistance 2 (R-2)—pivot point number plus the high minus the low.
R-2 = P + H – L
• Resistance 1 (R-1)—pivot point number times two minus the low.
R-1 = (P × 2) – L
• Support 1 (S-1)—pivot point number times two minus the high.
S-1 = (P × 2) – H
• Support 2 (S-2)—pivot point number minus the high plus the low.
S-2 = P – H + L
Some analysts are adding a third level to their pivot calculations to
help target extreme price swings that have occurred on certain occasions,
such as a price shock resulting from a news event. I have noticed that the
spot forex currency markets tend to experience a double dose of price
shocks because they are exposed to foreign economic developments and
U.S. economic developments that pertain to a specific country’s currency.
This tends to make wide trading ranges. Therefore, a third level of projected
support and resistance was calculated.
• Resistance 3 (R-3)—the high plus two times (the pivot minus the low)
R-3 = H + 2 × (P – L)
• Support 3—the low minus two times (the high minus the pivot)
S-3 = L – 2 × (H – P)
or
R-3 = P – S-2 + R-1
S-3 = P – R-2 – S-1
Pivot Point Analysis, Filtering Methods, and Moving Averages 67
There are other variations that include adding the opening range,
which, in this case, would involve simply taking the sum of the high, the
low, and the open, and the close and dividing by four to derive the actual
pivot point.
P = (O + H + L + C) /4
Since there is no formal closing and opening range, forex traders can
use the N.Y. bank settlement as the close at 5 P.M. (EST) and assign the next
day’s session open as 5:05 P.M. (EST).
The following list shows what these numbers represent, how price action
reacts with these projected target levels, how the numbers would
break down by order, what typically occurs, and how the market can behave
at these levels. Keep in mind that this is a general description, and we
will learn what to look for at these price points to spot reversals in order to
make money. I must stress that it is important to look at the progressively
higher time period’s price support or resistance projections; for example,
from the daily numbers, look at the weekly figures; and then from the
weekly numbers, look at the monthly numbers. The longer the time frame,
the more important or significant are the data. Also, it is rare that the daily
numbers trade beyond the extreme R-2 or S-2 numbers; and when the market
does, it is generally in a strong trending condition. In this case, we have
methods to follow the market’s flow, and we will cover them in more detail
in the next few chapters. Remember, pivot point analysis is used as a guide;
these numbers are not the holy grail. By focusing on just a few select numbers
and learning how to filter out excess information, I eliminate the analysis
paralysis from information overload.
• Resistance Level 3—This is the extreme bullish market condition generally
created by news-driven price shocks. The market is at an overbought
condition and may offer a day trader a quick reversal scalp
trade.
• Resistance Level 2—This is the bullish market price objective or target
high number for a trading session. It generally establishes the high of a
given time period. The market often sees significant resistance at this
price level and will provide an exit target for long positions.
• Resistance Level 1—This is the mild bullish to bearish projected high
target number. In low-volume or light-volatility sessions or in consolidating
trading periods, this often acts as the high of a given session. In
a bearish market condition, prices will try to come close to this level
but most times will fail.
• Pivot Point—This is the focal price level or the mean, which is derived
from the collective market data from the prior session’s high, low, and
68 FOREX CONQUERED
close. It is the strongest of the support and resistance numbers. Prices
normally trade above or below this area before breaking in one direction
or the other. As a general guideline, if the market opens above the
primary pivot be a buyer on dips. If the market opens below this level,
look to sell rallies.
• Support Level 1—This is the mild bearish to bullish projected low target
number in light-volume or low-volatility sessions or in consolidating
trading periods. Prices tend to reverse at or near this level in bullish
market conditions but most times fall short of hitting this number.
• Support Level 2—This is the bearish market price objective or targeted
low number. The market often sees significant support at or near this
level in a bearish market condition. This level is a likely target level to
cover shorts.
• Support Level 3—In an extremely bearish market condition, this level
will act as the projected target low or support area. A price decline to
this level is generally created by news-driven price shocks. This is
where a market is at an oversold condition and may offer a day trader
a quick reversal scalp trade.
Weekly and monthly time frames can and should be utilized as well as
the daily numbers you may be used to or have heard about in the past. To
understand how price moves within the pivots, begin by breaking down the
time frames from longer term to shorter term. As traders, we should begin
with a monthly time frame, where there is a price range or an established
high or low for a given period. This range, with its price points, is what we
as traders should be looking for. Here is how I utilize the range in my research.
There are approximately 22 business days, or about 4 weeks, in
each month. Every month there will be an established range—a high and a
low. There are typically five trading days in a week. Now consider that in
one day of one week in one month, a high and a low will be made. It is likely
that this high and low may be made in a minute or within one hour of a
given day of a given week of that month. That is why longer-term time
frames, such as monthly or weekly, should be included in your market
analysis. In the world of 24-hour trading, the most popular question I get
from those studying and using pivot points is, “What are the times that you
derive the high-low-close information?” There are many different people
telling many different stories. Here is what I do and what seems to work the
best for me. For starters, just keep things simple, and apply some good oldfashioned
common sense. If the exchanges and the banking system use a
specific time to settle a market, then that is the time period that should be
considered for a “close.” They should know those are the rules that make
money move. I want to follow the money flow and be on the same time
schedule as the banks and institutions, so here are a few pointers:
Pivot Point Analysis, Filtering Methods, and Moving Averages 69
• Use the 5 P.M. (EST), New York bank settlement close to determine
pivots.
• For the weekly calculations, take the open from Sunday night’s session
and use the close on Friday.
• For the monthly calculations, take the opening of the first day of the
month and the close from the last day of the month.