What Are Pivot Points?
A pivot point is a price level that traders and analysts use to identify potential areas of market movement, specifically prospective support and resistance levels. Falling under the umbrella of technical analysis, pivot points are calculated based on the high, low, and closing prices of a preceding trading period, such as a day or a week. These calculated levels serve as forecasting tools, helping traders anticipate where price action might encounter a turning point or continue its prevailing direction. The primary pivot point itself acts as a central line, indicating whether the market sentiment is generally bullish or bearish.
History and Origin
The concept of pivot points has roots in early 20th-century trading, with their practical application widely attributed to floor traders in the commodities and futures markets. These traders, operating in fast-paced environments, needed a simple yet effective method to determine key price levels for the upcoming trading day. They would manually calculate pivot points using the previous day's significant price data (high, low, and close) to establish potential turning points and areas of interest16, 17.
While the exact origin is debated, renowned traders like Jesse Livermore, a prominent figure in the early 1900s, utilized similar concepts, referring to them as "pivotal points" to time his trades and capitalize on significant price movements15. Later, Nicholas Darvas, known for his "Darvas Box Theory," also focused on key price levels and breakouts, aligning with the core idea behind pivot points14. In more recent times, traders such as William O'Neil and Mark Minervini have further refined and popularized strategies incorporating pivot points, particularly in relation to identifying optimal buy points as stocks emerge from price consolidation areas13.
Key Takeaways
- Pivot points are calculated price levels derived from a prior period's high, low, and close prices.
- They serve as predictive indicators of potential support and resistance levels in financial markets.
- The main pivot point helps determine the overall market sentiment for a trading session.
- Traders use pivot points to identify potential entry and exit points and manage risk.
- While popular, the effectiveness of pivot points can vary and they are often best used in conjunction with other analytical tools.
Formula and Calculation
The most common method for calculating pivot points is the "Classic Pivot Point" formula. This system typically generates a main pivot point (P), along with three levels of support (S1, S2, S3) and three levels of resistance (R1, R2, R3). These levels are determined using the high, low, and closing prices from the previous trading period.
The formulas are as follows:
These calculations provide a framework of levels that traders monitor throughout the trading session. The "Previous High" and "Previous Low" refer to the highest and lowest prices reached in the prior period, while "Previous Close" is the final price of that period. These values are fundamental for determining the potential trading range and future price behavior.
Interpreting the Pivot Points
Interpreting pivot points involves observing how price action interacts with the calculated levels. The main pivot point (P) is a crucial reference. If the price of an asset opens and trades above the pivot point, it often indicates a bullish market sentiment for the period. Conversely, if the price trades below the pivot point, it suggests a bearish bias.
The support levels (S1, S2, S3) are areas where buying interest might emerge, potentially halting a price decline and leading to a bounce. The resistance levels (R1, R2, R3) are areas where selling pressure might increase, potentially stopping a price rally and leading to a reversal. Traders look for confirmation through candlestick patterns or other indicators when price approaches these levels. A break above a resistance level or below a support level can signal a continuation of the trend or a significant shift in momentum, providing valuable insights into potential future price action.
Hypothetical Example
Consider a hypothetical stock, "DiversiCo Inc." On Monday, it had a high of $105.00, a low of $100.00, and closed at $104.00.
Using the Classic Pivot Point formulas for Tuesday's trading:
- Pivot Point (P): (\frac{105.00 + 100.00 + 104.00}{3} = \frac{309.00}{3} = 103.00)
- Resistance 1 (R1): ((103.00 \times 2) - 100.00 = 206.00 - 100.00 = 106.00)
- Support 1 (S1): ((103.00 \times 2) - 105.00 = 206.00 - 105.00 = 101.00)
- Resistance 2 (R2): (103.00 + (105.00 - 100.00) = 103.00 + 5.00 = 108.00)
- Support 2 (S2): (103.00 - (105.00 - 100.00) = 103.00 - 5.00 = 98.00)
On Tuesday, a day trader observes DiversiCo Inc. trading. If the stock opens near $103.00 and then starts to rise, breaching $103.00 and moving towards $106.00 (R1), it indicates a bullish momentum. If it reaches $106.00 and struggles to move higher, the trader might anticipate resistance and consider a short position or take profits on a long position. Conversely, if the stock falls below $103.00 and approaches $101.00 (S1), it suggests a bearish bias, and the trader might look for signs of a bounce before considering a long position, or a break below S1 to potentially enter a short trade. This provides clear reference points for a trading strategy.
Practical Applications
Pivot points are widely used across various financial markets, including the stock market, forex market, and commodities, primarily by short-term traders. Their static nature provides fixed levels that do not change during the trading session, offering clear reference points for decision-making12.
In day trading, pivot points are invaluable for identifying intraday price movements and setting realistic profit targets and stop-loss levels11. Traders can use these points to gauge the market's direction, with trading above the main pivot point suggesting a bullish trend and below indicating a bearish trend10. For instance, a trader might look to buy if the price breaks above R1 with strong volume, or sell if it breaks below S1.
Beyond technical analysis, the broader economic environment also influences market movements that traders using pivot points consider. For example, decisions by the Federal Reserve regarding interest rates can impact market liquidity and overall sentiment, which in turn affects how prices interact with pivot levels9.
Limitations and Criticisms
Despite their popularity, pivot points have limitations. One common criticism is that they are considered a lagging indicator because they are calculated using historical price data8. This means they may not always accurately predict future price movements or provide timely signals. Additionally, pivot points do not account for market volatility, which can lead to situations where prices easily break through these levels, especially during periods of high price fluctuations6, 7.
Furthermore, academic studies and research have offered mixed conclusions regarding the consistent effectiveness of pivot points in traditional applications. Some research suggests that while pivot points provide a framework for analyzing price action, they do not guarantee future price movement and may not reveal useful information about intraday price patterns in certain markets, such as the forex market, when used in their traditional way4, 5. Some analyses have even suggested that support levels might act as selling signals and resistance levels as buying signals, implying an inverse application could be more effective in specific scenarios3. Therefore, relying solely on pivot points without combining them with other forms of chart patterns or economic indicators can be risky2.
Pivot Points vs. Support and Resistance
While pivot points are often described as a form of support and resistance, there is a key distinction. Traditional support and resistance levels are identified through historical observation of price action, often appearing as horizontal lines where price has repeatedly found floors or ceilings. They are dynamic and can be subjective, often adjusted by traders based on evolving market conditions and trend lines.
In contrast, pivot points are calculated mathematically using a specific formula, providing precise, static levels for a given trading period1. They are predictive, attempting to project where support and resistance might occur based on the previous period's price range. While both concepts aim to identify areas where supply and demand imbalances could lead to price reversals or continuations, pivot points offer a more objective and standardized set of levels, whereas traditional support and resistance can be more discretionary and require historical context.
FAQs
How often are pivot points calculated?
Pivot points are typically calculated daily for intraday trading, but they can also be calculated weekly, monthly, or even annually for longer-term analysis. The choice of timeframe depends on the trader's strategy and the market being analyzed.
Can pivot points be used in all financial markets?
Yes, pivot points are versatile and can be applied to various financial markets, including stocks, forex, commodities, and indices. They are particularly popular in markets with high liquidity and short-term price movements.
Are pivot points a standalone trading strategy?
While pivot points offer valuable insights, they are generally not recommended as a standalone trading strategy. Most successful traders combine them with other technical analysis tools and indicators, such as volume analysis, moving averages, or candlestick patterns, to confirm signals and increase the probability of successful trades.
What does it mean if the price breaks through S3 or R3?
A break below S3 (Third Support) or above R3 (Third Resistance) suggests an exceptionally strong trend in that direction. These levels represent extreme price movements for the period and indicate that the prevailing market trend is very robust. Traders might interpret such breakouts as signals for a significant continuation of the move.