Pivot points are a series of price levels that act as support or resistance. The number of orders executed at or close to these points have a tendency to be higher than other points. When several of these levels are close together, that area creates even a stronger support or resistance point. Many non-novice traders take these points into consideration for every trade. There are many services that provide these daily calculations for subscribers for a fee.
R1, R2, R3: Calculated resistance points.
Fib 1.618 and Fib 1.272: . Fibonocci.
D2 Hi: High of two days ago.
High: High of yesterday.
Close: Close of yesterday.
D3 Hi: High of three days ago.
Pivot: The main pivot point.
Open: Open of yesterday.
Low: Low of yesterday.
D2 Low: Low of two days ago.
D3 Low: Low of three days ago.
S1, S2, S3: Calculated support points.
Why these levels work?
In my opinion the main reason that they work is that many traders think they should work. In other words, it acts as a "secret" between those traders. The ones who know are more likely to get in/out of a trade at a more favorable spot and the ones who don't know are more likely to get caught in a market move against them.
Some of these levels work based on simple human psychology of trading regardless of their knowledge about these levels. For example a typical average person trader Joe buys at say $1000 thinking the price is going to move up. The price moves up to $1010 validating his initial decision. At this point he is happy, proud, greedy and his cocky attitude tells him the price is going to move even higher. But the price drops and closes below $1000 which leaves him in the red zone for the night. That leaves Joe with a feeling of regret "why didn't I sell it when I had made all that money?". The next day he anxiously watches the market, this time he feels helpless, lost, fearful, looser, frustrated and no confidence. Joe is not religious but prays to higher beings for help. Finally his prayers are answered and the market moves to the type of profit which he tasted the day before. Joe sells immediately. If many Joe's sell at this point, the price can not go any higher. This was one example that the high of yesterday creates a psychological resistance level.
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| Sunflower florets in spirals of 34 and 55 around the outside Please note 34/55 = 0.618 and 55/34 = 1.618 which we use. |
How to use Pivot points in trading?
When price moves and approaches one of this levels, the traders may be more inclined to buy/sell at or slightly before that level. Therefore, many times when the market reaches one of these levels, it shows a sideways movement for a while before deciding on a new direction.
There are times when the price gets close to a level or hits it and immediately reverses. Other times cuts through the level and continues the trend.
If the price breaks through a support resistance level, it may show a tendency that the price in going to continue in the same direction. Many traders place their breakout orders right after such level.
These levels can be used in many ways. The most common way is to adjust your buying and selling points. For example, if you are long and you have a target set at 1122.25 while an important level is at 1122, you may want to adjust your target to at or below 1122. You give up a small portion of potential profit in exchange for increasing the odds of success. If you want to enter a long trade just below an important level, you may want to wait until that level is violated before entering the market.
Another way to utilize these levels is to break a large target into smaller ones based on the levels. This was you can make several trades out of a larger target.
Another way of using these levels is by observing the market reaction to them. If the price cuts through an important level with no hesitation, it indicates the strength of the market in that direction. By watching market behavior around these levels, one can get a feeling about more likely direction of the market.
Do these levels always work?
The answer is a big NO. In market there is nothing 100%. Just like other methods and indicators for trading, you will have to combine several of them together in order to get a reasonable odds for success. Pivot points by themselves are not signals for trading. They should be considered a tendency of the market. When you combine this concept with any viable signals, you will have a chance to improve your results.
There is an analogy between our brain and fertilization of female eggs. When one sperm enters the egg, the egg produces a chemical reaction that prevents other sperms to approach the egg in the same manner. Similarly, the first idea that gets to our brain gets priority over any subsequent ideas. In market we need to have an active open mind at all times. These pivot levels are just one "sperm".
Sunflower photo is courtesy of http://creativecommons.org/
