Trading with pivot points

Source: futuresmag.com

Support and resistance levels often identify price points where major moves take place, but how do you identify support and resistance? Traders use many methods for finding these key areas, including past areas of interest, simple mathematic equations and sophisticated computerized trading models. Often, simple, objective and easily calculated tools are best because they tend to perform consistently over time and work in a wide variety of markets and time frames. One indicator that fits these criteria is Woodie’s pivot point. We will discuss how to calculate, interpret and use this technical tool, focusing on day trading and swing trading.

The Woodie’s pivot point is the level at which the market direction changes for the day. Woodie’s pivot points are used to determine trading levels at which the trend is inclined to change direction and head to possible support and resistance. They are designed to be trend-predicting indicators instead of lagging indicators.

In some ways, pivot points can be a self-fulfilling prophecy. Many traders follow them, which causes the market to react at these levels. 

Calculation

In this day and age of instant calculations, it may seem quaint to talk about manual calculation. It’s important when possible to understand the math behind your indicators.

To calculate the Woodie’s pivots use the formulas below. R1-R3 denote resistance levels. PP refers to the pivot point. S1-S3 are support levels. The support and resistance levels that are calculated from the formulas indicate the potential trading ranges for the next trading session. 

To calculate the pivot level, we need three prices, which are:

H = Previous day’s high price
L = Previous day’s low price
O = Current day’s opening price

The formula for the pivot point is:

PP = (H + L + (O * 2)) / 4

Support and resistance levels are then calculated. The first support and resistance levels are calculated using the difference between the pivot point and the previous day’s high and low prices:

R1 = (2 * PP) - L
S1 = (2 * PP) - H

The second support and resistance levels are based on the width of the trading range (high - low) and are calculated as:

R2 = PP + (H - L)
S2 = PP - (H - L)

The third support and resistance levels are calculated as:

R3 = H + 2 * (PP - L)
S3 = L - 2 * (H - PP)

These prices are generally taken from a stock or futures contract’s daily chart, 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, 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.

Analysis

The most important level is the pivot level itself, above or below where the price move will occur toward the support and resistance levels.

It is extremely rare for a stock index to hit its daily R3 or S3 levels. If a market or individual stock rallies until R2 or sells off until S2, this often ends up being the high or low of the day. Knowing this will help temper your emotions and keep you on track to follow this system. 

In the context of applying this indicator, we consider the pivot point the trend-deciding level for a particular day. This allows us to derive three basic rules for trading with pivots:

• If the market/stock trades above the pivot point, then the bias for the day is on the long side. Buying is advisable. 
• If the market/stock trades below the pivot point, then the bias for the day is on the short side. Short selling would be the preferred strategy.

If the market opens gap up or gap down, and trades near R2/R3 or S2/S3, it will exhibit a tendency to trade back toward the pivot. Thus, the general rule to follow is to “avoid buying the high or selling the low.”
If either of S1 or R1 is penetrated, these breakout points will reverse their roles. That is, the first support (S1) becomes the new resistance (R1). 

Trade examples

We’ll demonstrate the pivot system with the S&P 500 price action on Sept. 24, 2014, and show how you might have traded using this technique.

On Sept. 23, the S&P 500 recorded the following:

High: 1995.41
Low: 1982.77
Close: 1982.77

On Sept. 24, the market opened at 1983.34. This gave us the following pivot levels:

PP: 1985.93
R1: 1989.09
R2: 1998.57
R3: 2001.73
S1: 1976.45
S2: 1973.29
S3: 1963.81

“S&P levels” (below) illustrates how the market action on Sept. 24 played out in the context of pivot point analysis. The S&P 500 opened at 1983.34 and immediately started going down. As per the Woodie’s pivot point strategy, we take a long trade above the pivot at 1985.93, keeping a stop loss of two points in place.

The first target for the trade is R1 at 1989. At this level, a trader either can book profit or protect the position by moving the stop loss to breakeven and trailing behind the market. The second target for the trade is R2 at 1998. At this level, a trader should book full profit. The high made by the S&P 500 on Sept. 24 was 1999.79, just above R2.
Let’s take another example of using pivot levels to trade on the short side of the market.

On Sept. 5, 2014, Verizon Communications Inc. had the following data:

High: 50.03
Low: 49.56
Close: 49.94

On the following Monday, on Sept. 8, the market opened at 49.87. This gives us the following levels:

PP: 49.83
R1: 50.11
R2: 50.3
R3: 50.58
S1: 49.64
S2: 49.36
S3: 49.17

“Communication breakdown” (below) shows the price action on Sept. 8 with respect to the pivot points. Verizon opened at 49.87. Per the pivot level system, we take a short trade below the pivot (49.83) with a stop loss at the day’s provisional high at this point (49.88).

The first target for the trade is S1 (49.64). At this level, a trader can either book profit or trail the position with a stop loss initially moved to breakeven, just as we did with the long trade. Likewise, the second target is S2 (49.36). The low made by Verizon on Sept. 8 was 49.40, which is just 4¢ short of the S2 target. Traders are advised to square off all positions in this type of day-trading strategy.

Now let’s look at an example that includes both a long and short trade. On Aug. 14, 2014, Apple had the following:

High: 97.57
Low: 96.80
Close: 97.50

The open on Aug. 8, was 97.90, giving us the following pivot values:

PP: 97.34
R1: 97.88
R2: 98.11
R3: 98.65
S1: 97.11
S2: 96.57
S3: 96.34

“Swing about” (below) includes the five-minute chart of Apple on Aug. 8. 

It shows how we could trade both sides of the market using the pivot levels. Apple opened gap up at 97.50, which is above the pivot at 97.34. As per the pivot level system, we take a short trade when the market moves back below the pivot, with a stop loss at the day’s provisional high of 97.90.

The first target for the trade is S1 (97.11). At this level, a trader either can book profit or trail the position from the entry price. The second target is S2 (96.57). As seen in the chart, the stock was unable to move near this second target and eventually triggered the stop loss.

Now, as Apple starts trading above the pivot level, we can initiate a long trade at 97.40 with a stop loss of 97.00 and our first target being R1 at 97.88. The stock eventually reached this level in the last hour of trading, and we booked our profit.

Woodie’s pivot point levels are simple and accessible tools for day traders that provide a reliable way to identify potential market turning points. It’s important to keep in mind that pivot points, like any indicator, aren’t infallible and are most effective when combined with other techniques, such as candlesticks, oscillators and moving averages. Also, despite the simplicity of this tool, it is important to practice using it extensively before you attempt using it for actual trades.