Pivot points are a very popular way to gauge the bullish and bearish sentiment in the forex market. They were first developed by commodity traders to identify possible turning points (support and resistance lines), and have shown to be a very effective trading tool in liquid markets like forex.
In addition, pivot points are calculated in an objective way, without any interference of the trader himself, compared to Fibonacci levels for example, where the trader needs to spot the swing highs and lows in order to draw the Fibonacci retracements.
This article will show you what pivot points are, how they’re calculated, and most importantly – how to use them in an effective way in your daily trading.
Video: Using Pivot Points in Forex Trading
What are Pivot Points?
Pivot points are used to identify possible support and resistance levels. The forex market, especially the most liquid pairs, have proved to work exceptionally well with pivot points. Forex traders use pivot points for entry and exit targets, and to objectively assess the risk of a trade as they can also be used to set stop-loss levels.
Let’s take a look on the next chart, which shows pivot points applied to the EUR/USD currency pair.
As you can see, pivot points consist of seven lines in total: the daily pivot (PP), the daily support 1, daily support 2, and daily support 3 lines below the daily pivot, and the daily resistance 1, daily resistance 2 and daily resistance 3 lines above the daily pivot.
Note that the support and resistance lines work the same way as traditional horizontal support and resistance lines. When the price approaches one of the support levels, there is a high probability that it will bounce and reverse – and the same applies to the resistance levels. However, once a support or resistance line breaks, it will change its nature and become a resistance or support line, respectively.
This is an additional reason why pivot points work so well in the forex market, as the high liquidity ensures the absence of any type of market manipulation and technical support and resistance levels tend to be respected by market participants around the world – to such an extent that they become almost self-fulfilling.
How to Calculate Pivot Points Calculation
Pivot points are calculated based on the previous day’s high, low and close prices. Once all pivot points are calculated, they remain valid for the current trading day and can be displayed and traded on across all timeframes.
For example, the 30-minutes time frame (as in the example above) includes 48 candles, while the 4-hour timeframe includes six candles that relate to the current day’s pivot points.
The first step is to calculate the daily pivot points, using the formula below:
Daily Pivot Point = [High (previous day) + Low (previous day) + Close (previous day)] / 3
This pivot point is the used to calculate the remaining support and resistance levels for the current trading day:
Resistance 1 = (2 x Pivot Point) – Low (previous period)
Support 1 = (2 x Pivot Point) – High (previous period)
Resistance 2 = (Pivot Point – Support 1) + Resistance 1
Support 2 = Pivot Point – (Resistance 1 – Support 1)
Resistance 3 = (Pivot Point – Support 2) + Resistance 2
Support 3 = Pivot Point – (Resistance 2 – Support 2)
Please note that some trading platforms use a different way to calculate the Resistance 3 and Support 3 levels, which is shown below:
Resistance 3 = High (previous period) + 2 x (Pivot Point – Low (previous period))
Support 3 = Low (previous period) – 2 x (High (previous period) – Pivot Point)
Of course, you don’t have to calculate these levels by yourself, as all popular trading platforms already have pivot points in their list of technical indicators.
How to Use Pivot Points in Trading
Let’s get to the interesting part – how can you use pivot points in trading? Well, the first thing you should analyze is the current market condition. Is the market ranging or trending? Depending on this, you will use pivot points either to trade bounces or to trade breakouts out of the pivot points. Basically, as we already said, pivot points act as normal support and resistance lines and are used to identify possible turning points in the market.
Traders use pivot points the same way as they’d use traditional support and resistance levels. This means, when the price approaches a resistance level, a sell opportunity arises. And when the price approaches a support level, a buy opportunity arises. Let’s take a look at the following chart, which shows a 1-hour chart of EUR/USD.
At point (1), the price reached the Support 3 pivot point, which is a strong signal that we could see a reversal. It creates a buying opportunity, with a stop-loss just below the Support 3 level.
Point (2) marks the price at the Resistance 3 level, which again creates a selling opportunity with a stop-loss above the R3 level. The price bounced off the R3 level and went all the way down to the S1 level (Point 3), which is also our profit-taking level. Remember to look for additional confirming signals and don’t rely only on pivot points. As you can see at point (3), a hammer pattern formed which signals that the price might reverse again. Again, we could enter here with a buy order and put the stop-loss just below the S1 level.
Point (4) is our exit target and simultaneously opens the possibility to enter with a sell order. The pinbar briefly touched the Resistance 2 level and reversed to make a new swing low. With the break of the daily pivot at point (5), we could enter with a buy order and look to exit at the next day’s Support 1 level.
Pivot points are an effective tool to analyze and identify possible turning points in the market. Once all pivot points are calculated for the current day, they remain valid throughout the trading day and can be traded on different timeframes. You can use pivot points the same way as you’d use traditional support and resistance lines, and trade both the bounces and breakouts depending on whether the market is ranging or trending.