PIVOT POINT MOVING AVERAGE SYSTEM

PIVOT POINT MOVING AVERAGE SYSTEM
The moving average is one of the most widely utilized indicators in technical
analysis because the moving average is easy to identify and easy to
back-test. Many automated trading systems use moving averages or some
derivation of a moving-average method to generate buy and sell signals.
Moving averages are considered classic indicators and are very popular
with traders today. Most technicians view the moving average as a way to
signal a change in the direction of the trend, as well as a way to smooth out
the volatility of the market.
The Simple Moving Average
The simple moving average (the arithmetic mean) is the most popular moving
average used in technical analysis. The simple moving average is the
sum of the closing prices over several sessions divided by the number of
sessions. For example, a 20-day moving average would be the sum of the
preceding 20 days’ closing prices divided by 20. As new data is added to the
calculation, old data is removed: Each new day would drop the first day’s
closing price and add the new day’s closing price. By averaging the price
data, a smoother line is produced, and the trend is much easier to recognize.
The disadvantages of the simple moving average are that it only takes
into account the time period of the sessions covered in the calculation and
it gives equal weight to each day’s price.
The moving average is the average of the closing prices (sometimes referred
to as the settlement price) of a defined number of sessions. The
moving average is a lagging indicator. The purpose of the moving average
is to indicate the beginning and the ending of a trend. Since the moving average
follows the market, the signals it generates occur after the trend has
already changed.
It has been postulated that most traders lose their money in the mar-
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kets. If most traders focus on moving-average values that are predetermined
by default settings in their charting software packages or that use the
media’s favorite 200-day moving average, it’s no wonder they lose. They
are all following the same indicator, and a tremendously lagging indicator
at that!
Be Smarter and Faster Than the Next Guy
If you want to make consistent profits, then you need to think and use a different
set of values or understand how signals are generated. Also, you do
not want to follow and base your trading strategies on what everyone else
is looking at to enter or exit positions. So when it comes to moving averages,
you want to look at different sets of conditions and time periods.
Think for just a minute: If lots of traders are watching for trade signals on
20-, 50-, 100-, or 200-period moving averages, and if it is true that the majority
of traders lose money, then why do I want to take trade signals based
off those moving-average values? Some traders and technical analysts use
various ways to calculate such moving averages as the simple, the
weighted, and the exponential. I prefer the simple moving average and a different
set of values for my moving average, namely the pivot point. As you
will recall, the pivot point calculation provides the mean (average) for the
session’s trading range (P = H + L + C/3).
The moving-average section discusses how the moving average helps
clarify the market’s price flow by extending price analysis over a certain period
of time. In this manner, moving averages can demonstrate when a market
enters an extreme condition by how far it departs from the mean. Price
action will move toward either the moving average in which it acts as a support
or the resistance number. What I use is the combination of the price
session information (H + L + C/3) known as the pivot point number over a
specific period of time (moving average). This value utilizes cumulative
data from the high, the low, and the close for a session; and, more important,
the information provides a clear picture of the “average true price” for
that time period. This moving average value I use is calculated by taking the
pivot number from the past three periods. The time frames I use are daily,
weekly, and monthly periods. It is important to note, however, that the
longer the time frame, the more significance the number will hold. To calculate
the market direction number, add three pivot points from the same
session and divide by three. The purpose of using the pivot point as a
moving-average calculation is that the pivot point gives me a truer sense of
market value for a given period in time.
Pivot + Pivot + Pivot
3
Pivot Point Analysis, Filtering Methods, and Moving Averages 85
The three-period pivot point moving average can act as a support number
in bullish conditions and has a high degree of importance when one of
the pivot point calculations for the current session coincides with the moving
average or is close to it. This value holds true as a resistance number in
a bear market condition. If other numbers coincide with the pivot point
moving average, such as the actual pivot point or an R-1 number, then it
would serve as the target high number for that specific time period. Another
way of using the three-period pivot point moving average is as a point
of reference or fair value. When the market price departs or deviates too far
from the mean, then you can use the extreme support or resistance number,
such as S-2 or R-2, or the farthest target number of that direction as a
potential turning point.
When various time frames are incorporated into the analysis (daily,
weekly, and monthly), there is more certainty that the target price level can
generate the anticipated reaction. If the market gaps too far from the daily
pivot point moving average, use the monthly and/or weekly target support
and resistance numbers to help identify a targeted reversal support or resistance
point.
Figure 2.15 shows a spot forex British pound daily chart with the threeperiod
pivot point moving average overlaid on top of prices. Notice that as
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FIGURE 2.15 British Pound/U.S. Dollar (60-minute bars)
Used with permission of GenesisFT.com.
the market changes conditions from bullish (uptrend) to bearish (downtrend),
prices tend to bounce off the moving average as a support line and
trade off the moving average as a ceiling of resistance. You should also notice
the topping price action. Now if we start with point A, you will see that
point B is higher in price. Look at the corresponding points in the moving
average values, and you will see that point B makes a higher high; but the
moving average value is lower than when it is at point A. This is what I identify
as a moving-average divergence. It serves as a strong clue that the market
has peaked and that a significant reversal is due. Pivot point moving
averages can help you filter out market noise (ranges) and can give you a
truer picture of the market’s value and direction.
The time period between point A and point B was a consolidation
phase, as prices moved above and below the moving average. The moving
average went virtually in a flat line with a bias to a downside slope. This
was hinting that prices were getting ready to change direction. When you
watch the moving average in relationship to the underlying price action,
sometimes you can get clues as to the true market price direction using the
pivot point average because it factors in the overall range and the relationship
that the close of each time period has to that range. If the close is
closer to the high, the average will be at a higher assigned value. As I just
stated, using the three-period pivot point average will help you filter out
much of the market noise and give you a truer sense of the market’s fair
value within the price range of the past three trading periods. This is very
helpful information because forex markets do go in range-bound consolidation
periods. These are called sideways channels, which we will discuss
in the next few chapters.
At times, the slope (or the angle) of the moving average can give you a
clue as to the market’s true strength or weakness, especially when combined
with candlestick charting. The slope helps filters out the noise and
shows you whether the market’s value is progressively appreciating or depreciating.
When a market goes from the trending phase into the consolidation
phase, it is the slope of the pivot point moving average that can help
you identify the next potential price direction from the consolidating phase
(e.g., a continuation or a trend reversal move). For added clarity, when you
use a pivot point moving average combined with the ability to identify a
high-probability bottom- or top-forming candle pattern, you have added
confirmation of a potential reversal move. The graph in Figure 2.16 shows
a representation of a pivot point moving average in a declining trend phase.
Then as prices consolidate, the pivot point average measures the typical
price rather than the close; and we can, therefore, determine what the true
market value is and which way prices tend to be moving. Markets sometimes
demonstrate extreme volatility at turning points. The moving average
approach can help filter out the noise inflicted by wide price swings. These
Pivot Point Analysis, Filtering Methods, and Moving Averages 87
swings often lead to confusion; or, worse, traders get whipsawed or
chewed up.
As the moving average slopes upward, it indicates that the market values
are also tending to trade higher. Eventually, we see a trend reversal,
which is what the direction of the moving average indicated. The threeperiod
pivot point moving average works as a tool to confirm triggers and
exits by showing price action closing above or below the moving average
pivot line as well as indicating the potential trend direction by looking at
the trend direction of the moving average itself. In Figure 2.17, I have a 30-
minute chart on the spot forex British pound. Looking at the consolidation
period as formed by an ascending triangle, we see that the market is starting
to change from a bearish trend condition to a consolidation phase; and
the upward slope of the moving average is giving a clue that the market may
move into a reversal. This is the clue you are looking for to make money by
watching for the reversal to occur, then entering in the market as it moves
to ride the momentum so you can profit. Trading is not about being bullish
or bearish, but just being in the market, on the right side, when it does
move. That’s how you will consistently make high-probability and profitable
trades.
The British pound chart in Figure 2.18 provides a good example of the
follow-through to the upside; and as prices continue higher, we see more
bullish confirmation that the market will continue to the upside with a hammer
candle pattern.
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FIGURE 2.16 Slope and Bullish Bias
As the market starts to move upward by establishing higher highs and
higher lows, you can see that it is also closing above prior highs and, most
important, closing above the three-period pivot point moving average. The
pivot point moving average will now start to act as a trend support.
Pivot Point Analysis, Filtering Methods, and Moving Averages 89
FIGURE 2.17 Profiting from Moving Averages
Used with permission of GenesisFT.com.
FIGURE 2.18 Moving Average Clues
Used with permission of GenesisFT.com.