Trading With Pivot Points In Forex

Pivot points have long been used by Forex traders as a means of determining directional changes in the markets.

Pivot points are calculated levels within the market that provide both potential support and resistance levels and also a leading indication as to which way the market might be heading.

The generally held view is that if the market trades above the pivot point, it is seen as having bullish sentiment. Conversely if the market trades below the pivot point it is seen as having bearish sentiment.

As well as providing the actual pivot point, the calculations also provide immediate support and resistance levels in the market known as ‘pivot levels’. These are projections of points where the market may slow up or reverse. Three levels of resistance are calculated above the pivot point as well as three levels of support below the pivot point. These are commonly referred to as R1, R2, R3 and S1, S2, S3.

Calculations for pivot levels are made from the open, high, low and close prices of a currency pair over a selected time period. These calculations can be made for daily, weekly or even monthly charts.

Pivot points are popular among traders as unlike many technical indicators they are considered a leading rather than a lagging indicator. This is because they signal potential levels of support and resistance in advance of the market reaching these levels.

With many traders using and reacting to pivot points there is a natural tendency for markets to respond to these levels. It is therefore beneficial to maintain an awareness of these pivot levels even if your current strategy relies on separate indicators for defining trade entry and exit points.

Calculating Pivot Points

The calculation of the levels is fairly straightforward. We include the calculation below for those who are interested in calculating their own levels.

To calculate the pivot point on a chosen timeframe you will need the open, high, low and close prices for the currency pair over the selected timeframe. The calculation is as follows:

• Resistance level 3 (R3) = HIGH + 2 * (Pivot - Low)
• Resistance 2 (R2) = PIVOT + (R1 - S1)
• Resistance 1 (R1) = 2 * PIVOT - Low
• Pivot Point (PP) = ( HIGH + CLOSE + LOW ) / 3
• Support 1 (S1) = 2 * PIVOT - HIGH
• Support 2 (S2) = PIVOT - (R1 - S1)
• Support 3 (S3) = LOW - 2*(High - Pivot)

The three most important pivot points are R1, S1 and the actual pivot point.

Alternatively many sites provide pre-calculated pivots for the major Forex pairs. You can of course generate your own levels by using a pivot point calculator.

Trading with Pivot Points

The basic idea behind pivot point trading is to use a move towards or break of R1 or S1 as an entry point. As the market reaches R2, R3 or S2, S3 it is likely to become increasingly overbought or oversold. These levels are then used as the exit points for the trade.

For example the market is just above the pivot point. Here your initial profit target would be set as R1 with a stop loss placed just below the pivot point. A break of this level would see R2 set up as the next profit target with the stop moved up to just below R1. If R2 is broke then so R3 becomes the new target and the stop is moved to below R2.

The same is true in reverse for short trades, remembering to move the stop loss behind the previous price target as each level is breached.

This approach is particularly suitable for breakouts type trades but it is also possible to successfully trade market pullbacks that occur between the levels.

For example if you identify the trend as ‘long’ and the market pulls back towards S1, you could then enter a trade with a stop just below S1 and an initial profit target of the PP.

While pivot points do not always work as precisely as we have seen here they are useful tool to add to your toolbox. They help to highlight areas of possible support and resistance in the market and can be successfully combined with other technical indicators to help validate trading setups.

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Using Fibonacci Retracement Levels

A popular tool used by many students of technical analysis are Fibonacci retracement levels. These are commonly used to find trade entry points. Unlike pivot points which seek simply to anticipate points of support and resistance, Fibonacci retracement levels calculate where a market is likely to bounce back to (retrace) after a preceding move. After this retracement the market is then expected to resume its original direction.

Fibonacci number Sequence

The Fibonacci sequence is an additive numerical sequence named after Leonardo Fibonacci of Pisa, an Italian mathematician of the late twelfth century. Leonardo analyzed a number of repeatable number formations found within nature to form the Fibonacci number sequence. Fibonacci numbers are formed by adding together the preceding two numbers in a sequence to find the next. For example 1+1=2, 2+1=3, 3+2=5, 5+3=8 etc.

Fibonacci Forex retracement ratios are derived from this numerical sequence. By dividing any number in the sequence by the following number we end up with 61.8. This is referred to as the 'Golden Number.' For example we divide the 3rd number (5) in the above sequence by the 4th number (8) we end up with a ratio of 61.8. This is true of the entire sequence. This is one of the retracement levels that we use in calculating Fibonacci retracement's.

Fibonacci Retracement Levels in Forex

The key to using Fibonacci is in identifying the start and end of major market moves. These two points represent the high and low of the move. In Fibonacci terms, think of these levels as representing 0.0% (the start) and 100.0% (the end) of the move. To confirm the end of a move you can use you use any of your preferred technical indicators or candlestick patterns.

Fibonacci retracement levels occur at defined points of this move: 23.2%, 38.2%, 50.0 % and 61.8% are the most commonly used retracement levels. These levels can easily be calculated by using a Fibonacci calculator. Simply input the high and low of the move into the Fibonacci calculator and click ‘calculate.’

Once the levels are calculated they can then be plotted on your chart and used to find trade entries in one of two ways.

The first way is to trade the retrace or pullback after the initial move. Effectively this is trading a temporary reversal or counter trend move. The second method is to wait for the market to retrace the levels and use this as an entry point to rejoin the original trend.

Below we look at examples of both trading approaches.

Using a Fibonacci Retracement Level To Trade a Pullback

Using Fibonacci to identify and trade pullback scenarios is a common tactic among Fibonacci technical analysis traders.

When trading in this way it is important to locate your stops properly and set realistic targets for taking profit. Th50.0% retracement level is often used as an attainable 'take profit' target and one that works well on the 4 hour chart.

On the EURGBP chart above our initial entry following the high would target the 50.0% Fibonacci retracement level with a stop placed at the limit of the initial move. If the 50.0% retracement target is reached we could then move our stops to break even for a free run at the 61.8% retracement.

In this example, our target at the 50.0% retracement was met although our free run at the 61.8% level was taken out by a market bounce.

A few sessions later we can see that despite efforts to move higher, the pair ends up retracing back to the 61.8% level and subsequently falls to complete a full 100% retracement. It is a common feature of Fibonacci that markets that retrace beyond the 61.8% level, will often tend to retrace the whole of the preceding move.

Using Fibonacci Retracements to re enter a trend

As well as using Fibonacci retracement levels to trade trend consolidations, our next example shows how we can apply a Fibonacci retracement level as a point to re enter prior trends.

We have marked out a move of the 4 hour charts which took the USDCHF from just over 1.06 to 1.0840. The first sign we get of an impending retrace is the long wicked candle on the next four hour bar following the moves high.

In the following hours the market falls back through each of the retracement levels. These limit any additional gains for the duration of the retracement. As we can see from the above example the full 61.8% retracement is just shy of being met.

Failure to break support at the 61.8% level acts provides an entry point to rejoin the prior trend. Here our target would be the previous high recorded by the initial move. This was a particularly profitable move as the market then went on to break the previous high.

Fibonacci technical analysis is like any other technical trading approach in that it provides approximations of market levels rather than absolute targets. Quite why the numbers work is difficult to say. It may well be that the number of traders who watch these levels help to make Fibonacci retracement levels a self fulfilling prophecy. Whatever the reason, Fibonacci retracement levels prove a useful tool addition for every Forex traders toolbox.

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