It is useful to be able to see where the price is relative to previous market action. So we can see how is the sentiment of traders at any given moment and it also gives us a general idea of where the market is going during the day. This information can help us to decide which way to trade.
Pivot points are a technique which is developed by floor traders. They help us see where the price is relative to previous market action.
As a definition a pivot point is a turning point or condition. In the Forex market it is the same: the pivot point is a level in which the sentiment of the market changes from "bull" to "bear" or vice versa. If the market breaks this level up the sentiment is said to be a bull market and it is likely to continue its way up. If the market breaks this level down the sentiment is bear and it is expected to continue its way down. Also at this level the market is expected to have some kind of support/resistance and if the price can not break the pivot point a possible bounce from it is possible.
Pivot points work best in liquid markets like in the Forex market but they can also be used in other markets as well.
A pivot point is a level in which the sentiment of traders changes from bull to bear or vice versa.
Why do pivot points work?
They work because many individual traders use and trust them as well as bank and institutional traders. Every trader knows that the pivot point is an important criterion of strength and weakness of any market.
Calculating pivot points
There are several ways to get to a Pivot point. The method for the most accurate results is calculated by taking the average of the high, low and close of a previous period or session.
Pivot point (PP) = (High + Low + Close) / 3
Take e.g. the following EUR/USD information from the previous session:
The PP would be, PP = (1.2474 + 1.2376 + 1.2458) / 3 = 1.2439
What does this number tell us?
It tells us that if the market is trading above 1.2439 the bulls are winning the battle and pushing the price higher. If the market is below 1.2439 the bears are winning the battle and pulling the price lower. On both cases this condition is likely to sustain until the next session.
Because of the Forex market is open 24hr (no close or open from day to day) there is a timeless battle on deciding at white time we should take the open, close, high and low from each session. The times which produce more accurate predictions is taking the open at 00:00 GMT and the close at 23:59 GMT.
Besides the calculation of the pivot points there are other support and resistance levels which are calculated taking the pivot points as a reference.
Support 1 (S1) = (PP * 2) - H
Resistance 1 (R1) = (PP * 2) - L
Support 2 (S2) = PP - (R1 - S1)
Resistance 2 (R2) = PP + (R1 - S1)
Where is H the High of the previous period and L the low of the previous period
Continuing with the example above - Pivot point: 1.2439
S1 = (1.2439 * 2) - 1.2474 = 1.2404
R1 = (1.2439 * 2) - 1.2376 = 1.2502
R2 = 1.2439 + (1.2636 - 1.2537) = 1.2537
S2 = 1.2439 - (1.2636 - 1.2537) = 1.2537
These levels are suspected to mark support and resistance levels for the current session.
On the example above the pivot point was calculated by using information of the previous session (previous day). So we could see possible intraday resistance and support levels. But it can also be calculated by using the previous weekly or monthly data to determine such levels. By doing so we are now able to see the sentiment over longer periods of time. Also we can see possible levels which might offer support and resistance throughout the week or month. Calculating the pivot point in a weekly or monthly basis is mostly used by long term traders but it can also be used by short time traders to give you a good idea about the longer term trend.
S1, S2, R1 AND R2? An Objective Alternative
The pivot point zone is a well-known technique and it works simply because many traders use and trust it. But what about the other support and resistance zones (S1, S2, R1 and R2) to predict a support or resistance level with some mathematical formula is somehow subjective. It is hard to rely on them blindly just because the formula shows you that level. For this reason you can create an alternative way to map your timeframe in a simpler but more objective and effective way.
You calculate the pivot point as showed before. But your support and resistance levels are drawn in a different way. You take the previous session high and low and draw those levels on the chart today. The same is done with the session before the previous session. So you will have your pivot points and four more important levels which are drawn in your chart.
LOPS1, low of the previous session.
HOPS1, high of the previous session.
LOPS2, low of the session before the previous session.
HOPS2, high of the session before the previous session.
PP, pivot point.
These levels will tell you the strength of the market at any given moment. If the market is trading above the pivot point then the market is in a possible uptrend. If the market is above HOPS1 or HOPS2 the market is in an uptrend and you only take long positions. If the market is below the pivot point the market is in a possible downtrend. If the market is below LOPS1 or LOPS2 the market is in a downtrend and you should only have a look at short trades.
The psychology behind this approach is easy. We know that for some reason the market stopped there from going higher/lower the previous session or the session before that. You do not know the reason and you do not need to know it. You only know the fact: the market reversed at that level. You also know that traders have memories so that they do remember that the price stopped there before and the odds are that the market reverses from there again or at least find some support or resistance at these levels.
What is important about this approach is that support and resistance levels are measured objectively. They are not just a level which is derived from a mathematical formula and the price reversed there before so these levels have a higher probability of being effective.
Our mapping method works on both market conditions when the market is trending and on sideways conditions. In a trending market it helps you to determine the strength of the trend and trade off important levels. On a sideways market it shows you possible reversal levels.
How can we use the mapping method?
You can use the mapping method in three different ways: as a trend identification (measure of the strength of the trend), a trading strategy which is using important levels with price behavior as a trading signal and to set the risk reward ratio (RR) of any given trade which is based on where the market is relative to the previous session.