Pivot points are a system of support and resistance lines that can be calculated based on the previous day’s trading action. Pivot points are commonly used by day traders since they identify potential levels for long or short trades as well as limit and stop orders. Let’s take a closer look at what pivot points are, how they’re calculated, and how you can use them.
What Are Pivot Points?
The idea behind pivot points is that the previous day’s price high, low, and close will inform price action in the current session. Pivot points are calculated based on those three prices, and the resulting price level can be interpreted as a band of support or resistance for the trading day. In addition, pivot points yield an additional four price levels to keep an eye on – two support levels and two resistance levels.
This trading system is commonly used by intraday stock traders looking at 5- or 10-minute charts, in which case the pivot point is calculated from the previous day’s daily candlestick. However, it can also be used by swing traders when applied to slightly longer time horizons, such as for looking at daily charts with the pivot point based on a weekly candlestick. In addition, pivot points are often used in fast-moving commodity and forex markets.
Calculating Pivot Points
There are multiple ways to calculate pivot points, but the most common methodology is the five-point system. In this formulation, the pivot point is calculated as:
Pivot Point = (Previous High + Previous Low + Previous Close) / 3
Some traders like to also add the Previous Open, in which case you’ll divide by 4 instead of 3. “Previous” typically refers to the previous day when pivot points are used for day trading, but it can also refer to the previous week when used for swing trading. In 24-hour forex markets, market close in New York is most often used for calculating daily pivot points.
Based on the calculated pivot point, it’s possible to calculate the two support and two resistance levels:
Support 1 = (Pivot Point x 2) – Previous High
Support 2 = Pivot Point – (Previous High – Previous Low)
Resistance 1 = (Pivot Point x 2) – Previous Low
Resistance 2 = Pivot Point + (Previous High – Previous Low)
Most charting software will automatically calculate pivot points for you and display the support and resistance lines on your intraday charts. There are also plenty of pivot point calculators available online. However, you may have to do some manual work if you want to use an alternative system for calculating pivot points.
Trading With Pivot Points
Since pivot points are largely used to generate support and resistance lines, this system is traded much like any other support and resistance system. You will want to open a long position when the price breaks above a calculated resistance or a short position when the price breaks below a calculated support.
The main difference in this system is that the pivot point itself is considered to be the strongest support or resistance band, while the ancillary support and resistance lines are weaker. As such, a good rule of thumb when trading pivot points is to be bullish when the stock price is above the pivot point and bearish when the stock price is below it.
With this in mind, it’s possible to use the support and resistance lines created by trading pivot points to identify entry and exit points and to set stop losses and profit targets. As an example, when the stock price rises towards Resistance 1, you may place a buy limit order just above the resistance point and a stop loss just below it. If the trade executes, set your price target at or just below Resistance 2.
As an example, the 5-minute chart above shows pivot points in action. You can see that on several days, the bands calculated by pivot points accurately predict areas of support and resistance in the stock price. However, it’s also notable that pivot points don’t always work. When the stock gaps up strongly at open, the calculated resistance levels may not provide much useful information. (You can calculate additional Support 3 and Resistance 3 levels based on the pivot point in some systems.)
As with any technical trading tool, it’s important to be cautious when trading pivot points. While they can be a useful predictor or support and resistance levels, it’s also important to look at momentum indicators like MACD, as well as long-term trends in a stock’s price and news that may be affecting the price.
Conclusion: Pivot Points
Pivot points are a powerful tool for day traders looking to capitalize on quick movements in a stock’s price between support and resistance levels. Using pivot points makes it relatively straightforward to identify entry and exit points, which works well with a disciplined day trading strategy. Keep in mind, though, that pivot points don’t always respond well to intraday changes in trading activity based on news or other factors, so you need to be somewhat flexible when trading using this tool.