A popular way to detect support and resistance levels in a forex chart is by means of “Pivot Points”. Pivot points are a powerful instrument in technical analysis and can also be used as a part of a more extensive forex trading strategy. In this article we explain what pivot points are, how to calculate them, and how to apply them in your trading strategy.
Calculating pivot points
The most usual way to calculate pivot points (PP) is to take the mean of the high, the low, and the close of the previous day. So: PP = (H + l + C) / 3. This gives you a basis to find support and resistance levels for the current period. There are also alternative methods: some technical traders give a larger weight to the close, to better take into account the market consensus at the end of the period; others also consider the opening price of the previous period in their calculation. We will, however, just use the basic formula.
The choice to take the previous day as a point of reference originates from the time when this technique was mainly used by traders on the stock markets. The stock markets have fixed opening and closing times which clearly delimit a trading day. For forex this is different. The forex markets are opened 24 hours a day, 5 days a week. It is therefore somewhat arbitrarily to take the previous day as a point of reference. In fact, you could use every significant period which is neither too short nor too long. For example, you could use the 24 hours preceding the opening of the German stock market to determine the pivot point for the EUR/USD during the European session.
Based on pivot points, three support (S1 up to S3) and three resistance levels (R1 up to R3) can be calculated for the current period. The first levels (S1 and R1) are closest to the pivot point; the other levels are further away. This makes the S1 and R1 the most important levels: there is a large probability that these levels will act as a support or resistance. S3 and R3 are the strongest levels: the probability that these levels are pierced is very small, while at S1 and R1 this could happen more frequently.
You calculate the support and resistance levels as follows:
- R3 = PP + 2xH – 2xL
- R2 = PP + H – L
- R1 = 2xPP – L
- PP = (H + L + C) / 3
- S1 = 2xPP – H
- S2 = PP – H + L
- S3 = PP -2xH + 2xL
How do pivot points work?
The key to understanding pivot points is that many forex traders use them and base their stop loss or take profit on them. Because so many traders do so, it will eventually become support and resistance levels. Think about it: suppose the EUR/USD is approaching 1.3224 and this is an R1 level. Many traders will take their profit and sell their long positions. This sudden influx of Euros and decrease in US Dollars on the markets will cause the EUR/USD to stop rising and in most cases even to start falling.
Based on this principle you can make money with pivot points. How you can do so, we explain in section 2 of this article: Making money with pivot points. There we will explain how you can manually or automatically add pivot points to your forex chart, how to use them to predict the future direction of the market and how to determine the best entry and exit points.
Do you want to experiment with pivot points yourself? We would recommended the software of IG or Markets.com. They offer the most advanced trading software and work excellent for technical traders. Of course there are many other good brokers where you can trade based on pivot points. We have extensively tested many brokers in our broker review section.