For many years, traders and market makers have used pivot points to determine critical support and/or resistance levels. Pivots are also very popular in the forex market and can be an extremely useful tool for range-bound traders to identify points of entry and for trend traders and breakout traders to spot the key levels that need to be broken for a move to qualify as a breakout. In this article, we'll explain how pivot points are calculated, how they can be applied to the FX market, and how they can be combined with other indicators to develop other trading strategies.
By definition, a pivot point is a point of rotation. The prices used to calculate the pivot point are the previous period's high, low and closing prices for a security. These prices are usually taken from a stock's daily charts, but the pivot point can also be calculated using information from hourly charts. Most traders prefer to take the pivots, as well as the support and resistance levels, off of the daily charts and then apply those to the intraday charts (for example, hourly, every 30 minutes or every 15 minutes). If a pivot point is calculated using price information from a shorter time frame, this tends to reduce its accuracy and significance.
The textbook calculation for a pivot point is as follows:
Central Pivot Point (P) = (High + Low + Close) / 3
Support and resistance levels are then calculated off of this pivot point using the following formulas:
First level support and resistance:
First Resistance (R1) = (2*P) - Low
First Support (S1) = (2*P) - High
Likewise, the second level of support and resistance is calculated as follows:
Second Resistance (R2) = P + (R1-S1)
Second Support (S2) = P - (R1- S1)
Calculating two support and resistance levels is common practice, but it's not unusual to derive a third support and resistance level as well. (However, third-level support and resistances are a bit too esoteric to be useful for the purposes of trading strategies.) It's also possible to delve deeper into pivot point analysis - for example, some traders go beyond the traditional support and resistance levels and also track the mid-point between each of those levels.
Applying Pivot Points to the FX Market
Generally speaking, the pivot point is seen as the primary support or resistance level. The following chart is a 30-minute chart of the currency pair GBP/USD with pivot levels calculated using the daily high, low and close prices.
The green line is the pivot point (P).
The red lines are resistance levels (R).
The blue lines are support levels (S).
The yellow lines are mid-points (M).
Figure 1 shows how the pivot line served as support for the GBP/USD for most of the European trading hours. Once U.S. traders joined the market, however, prices began to break higher, with each of the breaks first testing and resisting either the mid-point or the R1 and R2 levels; then the break occurred off of those levels (see areas circled). This chart also shows something that occurs frequently in the FX market, which is that the initial break occurs at a market open. There are three market opens in the FX market: the U.S. open, which occurs at approximately 8am EDT, the European open, which occurs at 2am EDT, and the Asian open which occurs at 7pm EDT.
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What we also see when trading pivots in the FX market is that the trading range for the session usually occurs between the pivot point and the first support and resistance levels because a multitude of traders play this range. Take a look at Figure 2, a chart of the currency pair USD/JPY. As you can see in the areas circled, prices initially stayed within the pivot point and the first resistance level with the pivot acting as support. Once the pivot was broken, prices moved lower and stayed predominately within the pivot and the first support zone.
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