Forex Trading - Pivot Points

A technical indicator called 'Pivot Points' is becoming increasingly popular. The usefulness of any single technical indicator is always up for debate. But one thing is certain: pivot points are a valuable idea and should be part of every Forex trader's toolkit.

One possible reason pivot points have become so widely used is their sheer simplicity. Many indicators, such as Parabolic SAR or even Exponential Moving Averages, require some knowledge of fairly heavy duty mathematics to calculate. Many traders are reluctant to use an indicator that they only partly understand, and depth of understanding is only possible when you can calculate the indicator personally.

To calculate pivot points is simplicity itself. The formula is:

Pivot Point = (H+L+C)/3

where C is the currency pairs' closing price for a given day, H is the high for the previous 24 hour period and L the low. In short, the pivot point is simply the arithmetic mean (the 'average') of the three prices.

Picking the time for C is somewhat arbitrary since Forex markets trade 24 hours per day. C is often measured at the New York Forex market closing time, 4 p.m. EST. This number, usually denoted P, is used in conjunction with several others - called resistance and support points - in order to form the basis of a trading strategy. The resistance and support points are also simple to calculate. The formulae are as follows:

R1 = (P x 2) - L
S1 = (P x 2) - H
R2 = P + (R1 - S1)
S2 = P - (R1 - S1)

Of course, how to choose a price for the resistance and support levels is key and traders differ, even though there is often a consensus. Some strategies select the pivot point itself as a point of support or resistance, depending on the direction of recent price movements. Others will choose the closing price of the previous day.

If the price moves above the pivot point, trending upward, the market is tending bullish and vice-versa. In the first circumstance the pivot point would be a point of resistance, since prices 'resist' moving above that level. In the latter case, it's a support point.

Beyond attempting to evaluate trends, pivot points can be used as part of an entry and exit strategy. An investor might choose to place an order to purchase a currency pair if the price breaks through a resistance point.

Similarly, any good strategy will involve deciding in advance when to liquidate a position. Pivot points can be used to help select a stop-loss price in the event it moves below a support level.

No single indicator can be used reliably as the sole input to a good trading strategy. Pivot points, however, have been shown to perform well as part of an overall approach involving other indicators such as MACD (Moving Average Convergence/Divergence).

Owing to the enormous volume of transactions, currency prices are not much swayed by the action of any one trader, as is sometimes the case with stocks. That makes pivot points much more useful in Forex trading than in equity trading. Keep in mind, however, that such swings are possible as the result of central bank interest rate hikes, major political events and other fundamental factors.

Many analysts hold that pivot points achieve their useful status as a result of two tendencies.

If the day's price begins above the pivot point, prices will tend to stay above that point until it reaches the first resistance point. Remember, 'begin' is a somewhat arbitrary point in time in Forex trading. Alternatively, if the price begins below the pivot point, it will tend to stay below that point until it hits a support point.

Sometimes called 'trading between the lines', this is one popular approach. Traders wait for the reversal of the trend off a resistance point, then sell. Similarly, when the price trends upward after bouncing off a support point, a buy order can be triggered. If the market trades near R2 or S2, prices will tend to move back toward the pivot point.

Of course, this approach has to be viewed with some skepticism, as most strategies should be. Resistance and support points are broken all the time - that's what makes trading exciting. So, one has to wonder what makes those particular numbers resistance and support points.

To what degree those points influence trading decisions is a matter for debate. But, that they exist and have some influence is unquestionable.

It's always difficult to judge when a price movement is a temporary correction versus the beginning of a trend. By the time the trend is clearly established, it is often too late to profit. As with any form of trading, there's no substitute for experience as an aid to forming a sound, independent judgment.