In our quest to understand trading options for income, we often consider how we can use pivot points to help us trade more effectively. Pivot points, in my opinion, are far more effective on an intraday basis, especially when combined with volume using Market Profile.
While no one has been credited with inventing the pivot point, its use dates back to the late 1800s when Charles Dow first began trading. Pivot points are used mainly by floor traders, hedge funds, prop traders, and large speculators. Now that many trading platforms (like ThinkOrSwim) incorporate pivot point studies, it is becoming popular with retail traders as well.
Because of its wide use among professional traders, its effectiveness has been enhanced, especially in this day of high frequency (or programmed) trading. Pivot points are especially effective with the SPY and SPX (as you will see in sample charts), which are popular underlyings among professional traders.
Pivot points indicate potential support and resistance levels that traders and chartists use to indicate directional movement and possible reversals. Many traders use pivot points as a predictive (or leading) indicator of price movement.
Because it relies on a simple mathematical model, the pivot point is easy to implement, providing explicit numbers that other traders can replicate; there is no subjective interpretation required.
How are pivot points calculated? The formula for the Pivot Point is based on the High, Low, Close (H, L, and C) of a prior period; generally a Day, Week, or Month. A variation of the formula will substitute the Open (or O) of the current period for the Close (or C) of the prior period.
The Pivot Point (PP) is a central (or pivotal) level, based on: (H + L + C) / 3
If the price of the underlying is above PP, it is considered a bullish signal; and below PP it is considered a bearish signal.
Levels of Support (S1, S2, S3) and Resistance (R1, R2, R3) are calculated as follows: S1=(2xPP)-H; S2=PP-(H-L); S3=S1-(H-L); R1=(2xPP)-L ; R2=PP+(H-L) ; R3=R2+(H-L)
How do you use Pivot Points? Support and Resistance levels are key areas of consolidation and reversals. Traders will generally watch the price action when either a Support or Resistance level is reached.
When a price consolidates around a level during the morning, it is likely to continue in the same direction. If there is no consolidation (especially in the morning), then a reversal is likely.
Volume plays a key role in determining direction once a level is reached. During consolidation, volume will generally build (representing price acceptance), and follow-through in the same direction will likely occur.
It is best to have pivot points (and levels) for all three periods displayed on your chart (Daily, Weekly, and Monthly); this will encompass the most traders that watch or employ pivot points.
Let’s look at the example below (using 30 minute candle sticks) for some indication of market direction on the SPY. All three periods (Daily, Weekly, and Monthly) are used to generate the pivot points (including Support and Resistance levels). Those levels marked with an “o” (i.e., S1o daily; PPo daily) used the current day’s Open in place of yesterday’s Close.
The first 30 minute candle stick (or bar, from 9:30 am to 10 am ET) went as low as the S3o daily support line before rebounding.
The second 30 minute bar overshot support line S1 daily and nearly reached S2 daily before retracing (and ending above S1 daily). This was a considerable pull-back indicating a likely reversal in the morning.
The third bar consolidated for a short period around the close of the prior bar before heading further up past R1 monthly, and then pulling back to settle near R1 monthly. This small pull-back encourages traders to place short positions with stops placed near S2o daily.
The fourth bar (11 am to 11:30 am) forced the short positions to cover as it breached S2o daily support line, which led the SPY further up to bar six where consolidation at PP daily occurred. Consolidation leads to price acceptance and the likelihood of moving further up.
Bars seven and eight did move higher nearly reaching PPo daily before pulling back and consolidating with bar nine.
Bar ten moved down encouraging traders to place short positions which would enable further movement higher with short covering. This occurred with the remaining bars, reaching above PPo daily after the market closed.
In conclusion, while this example only looks at one day, it is typical of how the SPY tends to respect the lines generated by pivot points. As you become more familiar with this valuable tool, you will learn to use volume (through Market or Volume Profile) to help determine direction with greater accuracy.
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