Pivot point: Meaning, Criticisms & Real-World Uses

What Is Pivot Point?

A pivot point is a price level used by traders as a potential indicator of market movement. It is a concept within technical analysis, a discipline that evaluates financial instruments and attempts to forecast future price movements by analyzing historical price charts and market data. Traders commonly use pivot points to identify potential support levels and resistance levels, which are price thresholds where an asset's price tends to stop and reverse, or at least experience increased trading activity. The location of the price relative to the main pivot point is often used to gauge whether a particular trading session is experiencing a generally bullish market or bearish market bias.

History and Origin

The concept of pivot points has roots in early 20th-century trading floors. Renowned trader Jesse Livermore, famous for his speculation in the stock and commodities markets, utilized a concept he termed "pivotal points." He observed that significant price movements often occurred when stocks reached specific critical levels, allowing him to time his trades to capitalize on these directional shifts¹¹.

The modern application of pivot points is widely believed to have been developed by floor traders in the pits of commodities exchanges. These traders, operating in fast-paced environments, sought a simple, logical method to "frame their trade" at the start of each trading session¹⁰. They used the previous day's high, low, and closing prices to calculate a pivot point for the current day, along with associated support and resistance levels. This methodology provided a quick and practical way to determine potential turning points and assess market direction⁹,⁸. Over time, the concept evolved and was popularized by modern trading figures like William O'Neil and Mark Minervini, who integrated pivot points into their comprehensive trading strategy systems⁷.

Key Takeaways

A pivot point is a technical indicator derived from the high, low, and closing prices of a previous trading period.
It serves as a central point around which potential support and resistance levels are calculated.
Traders use pivot points to identify possible turning points in price, assess market sentiment, and plan entry and exit points for trades.
If the price trades above the pivot point, it suggests a bullish bias; if below, it suggests a bearish bias.
While widely used, pivot points are not foolproof and are often employed in conjunction with other technical analysis tools.

Formula and Calculation

The most common method for calculating pivot points is the Classic Five-Point System, which derives the pivot point (P) along with two or three levels of support and resistance. These calculations typically use the high (H), low (L), and close (C) prices from the previous trading period (e.g., previous day, week, or month).

The basic formulas are as follows:

\text{Pivot Point (PP)} = \frac{\text{Previous High} + \text{Previous Low} + \text{Previous Close}}{3}

From this central pivot point, the support levels and resistance levels are then calculated:

\text{First Resistance (R1)} = (2 \times \text{PP}) - \text{Previous Low}

\text{First Support (S1)} = (2 \times \text{PP}) - \text{Previous High}

\text{Second Resistance (R2)} = \text{PP} + (\text{Previous High} - \text{Previous Low})

\text{Second Support (S2)} = \text{PP} - (\text{Previous High} - \text{Previous Low})

Additional levels (R3 and S3) can also be calculated, providing more extreme potential price boundaries. These levels give traders a framework for anticipating potential price action within the current trading period.

Interpreting the Pivot Point

Interpreting a pivot point primarily involves observing the current price relative to the calculated pivot level. If a financial instrument's price trades above the central pivot point, it is generally seen as a sign of bullish market market sentiment, suggesting that buyers are in control. Conversely, if the price trades below the pivot point, it indicates a bearish market bias, implying sellers are dominant.

Traders often look for confirmation of these signals with other indicators or price action patterns. For instance, a strong move above the pivot point on increasing volume might indicate a breakout, while a rebound from a support level or a rejection at a resistance level could signal a reversal. The pivot point itself can act as a crucial turning point; if breached, it can become the new support or resistance level for subsequent price movements.

Hypothetical Example

Consider a stock market scenario for ABC Corp. On Tuesday, the stock's trading data was:

High: $105.00
Low: $100.00
Close: $103.00

To calculate the Classic Pivot Point for Wednesday:

\text{PP} = \frac{\$105.00 + \$100.00 + \$103.00}{3} = \frac{\$308.00}{3} = \$102.67

Now, let's calculate the first support and resistance levels:

\text{R1} = (2 \times \$102.67) - \$100.00 = \$205.34 - \$100.00 = \$105.34

\text{S1} = (2 \times \$102.67) - \$105.00 = \$205.34 - \$105.00 = \$100.34

On Wednesday, if ABC Corp. opens at $103.50, which is above the calculated pivot point of $102.67, it suggests an initial bullish market bias for the day. A day trading strategy might involve looking for further price increases towards R1 at $105.34. Conversely, if the stock opens below $102.67, say at $102.00, it signals a bearish bias, and traders might anticipate price declines towards S1 at $100.34.

Practical Applications

Pivot points are widely used across various financial markets, including the forex market, stock markets, and futures markets. Their primary application lies in helping day traders and short-term traders identify potential intra-day price reversals or continuations of a market trend.

Traders often use pivot points to:

Determine Market Bias: As discussed, trading above the central pivot point suggests a bullish sentiment, while trading below it suggests a bearish sentiment.
Identify Entry and Exit Points: The calculated support and resistance levels serve as potential entry point or exit point areas for trades. For example, a trader might enter a long position if the price bounces off S1, or take profits if it reaches R1.
Place Stop-Loss Orders: The pivot point and its associated levels can also be used as logical places to set stop-loss orders, helping to manage risk management by limiting potential losses.
Spot Breakouts: A sustained move beyond R2 or below S2 can signal a strong breakout or breakdown, indicating a significant directional move in price. IG International, a prominent trading platform, highlights the use of pivot points in identifying overall market trends and determining direction⁶.

Limitations and Criticisms

While pivot points are popular, they come with certain limitations and criticisms. One common critique is that, like many technical indicators, pivot points are lagging indicators. They are calculated using historical price data (past high, low, and close) and therefore may not always provide perfectly timely signals or accurately predict future price movements⁵. The market's inherent volatility and the influence of unpredictable external factors can undermine the reliability of these or any single technical indicator⁴.

Another point of contention is the "self-fulfilling prophecy" aspect. Because pivot points are widely used, many traders may react similarly when prices approach these levels, inadvertently contributing to price action around them. Critics argue that such collective behavior, rather than inherent predictive power, might explain their occasional effectiveness³. Furthermore, some academic research suggests that the effectiveness of pivot points can vary significantly depending on the trading rules, performance measures, and time periods studied, with some findings even indicating that pivot points might need to be implemented inversely in certain forex market scenarios². It is crucial not to rely solely on pivot points, but rather to use them in conjunction with other forms of analysis and sound trading strategy ¹.

Pivot Point vs. Support and Resistance

A pivot point is a specific type of support levels and resistance levels. The primary difference lies in their derivation and dynamic nature. Traditional support and resistance levels are often identified through visual analysis of historical price charts, marking areas where price has previously reversed. They can be subjective and may not always be precise lines but rather zones.

In contrast, pivot points are calculated precisely using a specific mathematical formula based on the previous period's high, low, and closing prices. This calculation provides objective, predefined levels for the current trading period. While both concepts aim to identify potential turning points in price, pivot points offer a systematic, quantifiable approach to defining these key levels, often making them a foundational element for day traders looking for clear, actionable price benchmarks.

FAQs

What does it mean if the price is above the pivot point?

If the price of a security is trading consistently above the main pivot point for a given period, it generally indicates a bullish market sentiment. This suggests that buyers are in control and the price may continue to rise towards the calculated resistance levels.

Are pivot points reliable on their own?

No, pivot points should not typically be used in isolation. While they are a valuable tool for identifying potential price levels, experienced traders often combine them with other forms of technical analysis, such as volume analysis, chart patterns, or other indicators, to confirm signals and increase the probability of successful trades. Relying solely on any single indicator carries inherent risks.

Can pivot points be used for long-term investing?

While the concept can be applied to longer timeframes (e.g., weekly or monthly pivot points), they are primarily favored by short-term traders, particularly day traders. This is because the calculation of pivot points resets with each new period, making them highly relevant for intraday or short-term market trend analysis rather than long-term investment strategies which typically rely more on fundamental analysis.