Pivot points have been used in technical analysis for quite some time and were originally used by floor traders who traded for their own accounts on the floor of the stock or commodities exchange. Pivot points represented an easy way for floor traders to have an idea of where the market was heading during the course of the day after performing only a few simple calculations on the close, high and low price of the previous day, and, in some cases, the open of the current day. Pivot points can be used as a predictive indicator to identify key support and resistance levels, which are called pivot levels, and can be used to forecast the short-term direction that the market will take during the course of the day.
In today's computerized age, a pivot point calculator can be used to quickly indicate up to seven pivot levels – three resistance levels named R1 (first resistance level), R2 (second resistance level) and R3 (third resistance level); the main pivot point (PP); and three support levels named S1 (first support level), S2 (second support level) and S3 (third support level), with S1, PP and R1 being considered the three main pivot levels. Pivot points can also be used to quickly determine market direction with the market considered bullish when it opens above PP, and bearish when it opens below PP.
Calculating Pivot Points
Calculating pivot points is fairly easy; all you need is the high, low, and close price for the previous period. However, there are a number of different formulae or methods that can be used to calculate the pivot points. The most widely used method is called the classic floor traders' method, which uses the average of the high, low and closing price for the previous period. Other calculation methods also take into account the open price for the previous period or the opening price for the current period.
The three common methods for calculating pivot points are:
- The classic or floor traders' method
- The Woodie method, which makes use of the current open price
- The Camarilla method
Less common methods include the Fibonacci pivots, and the DeMark method.
Classic Floor Traders Pivot Points
Classic pivot points are the most commonly used pivot points and rely on the high, low and close of the previous period to calculate the main pivot point using the formula:
( previous high + previous low + previous close ) / 3
The other levels are then calculated based on the main pivot point, the previous period's high, previous period's low, and the previous period's range (i.e., high - low).
Woodies Pivot Points
Woodies pivot points are similar to the classic pivot points with the exception that Woodies ignores the close price of the previous period and gives greater significance to the open price of the current period. Thus, the formula used to calculate the main pivot point using the Woodies pivot method is:
( previous high + previous low + ( 2 x current open ) ) / 4
The other resistance and support pivot levels are calculated the same as in the classic floor traders pivot method.
Camarilla Pivot Points
The Camarilla pivot point method was developed in 1989 by a successful bond trader named Nick Stott. Like the classic pivot points method, the Camarilla method also uses the average of the previous day's high, low and close price to calculate the main pivot. That is:
( previous high + previous low + previous close ) / 3
However, the other levels are calculated using the close price and the range ( high - low ) for the previous period. Of these other levels, the most significant levels are the R3 and R4 levels, as well as the S3 and S4 levels.
Fibonacci Pivot Points
The same classic formula is used to calculate the main pivot point for the Fibonacci method but then the key Fibonacci retracement levels of the previous period's range are used to determine the various support and resistance levels. The key Fibonacci retracement levels being the 100%, 61.8%, 50%, and 38.2% levels.
DeMark Pivot Points
DeMark Pivot Points were developed by Tom DeMark and are entirely different compared to other pivot points. For DeMark pivot points, the main pivot point is not significant. Only the R1 and S1 pivot levels are significant. However, the calculation for R1 and S1 differs depending on whether the previous period's close was higher, lower or equal to the previous period's open. If the close was higher, then the high is given more weight; if the close was lower, then the low is given more weight; and if the close is the same as the open, then the close is given more weight. For each of these conditions, the X is calculated and R1 and S1 are determined by using the formulae:
X / 2 - previous low and X / 2 + previous high for R1 and S1 respectively.
If the previous period's close is higher than the open that is the previous period closed up on the open then X is calculated using the formula:
( 2 x previous high ) + previous low + previous close
If the previous period's close is lower than the open that is the previous period closed down on the open then X is calculated using the formula:
previous high + ( 2 x previous low ) + previous close
Finally, if the previous period's close is at the same level as it's open then X is calculated using the formula:
previous high + previous low + ( 2 x previous close )
Some traders calculate the main pivot using the formula X / 4, but this is not an "official" DeMark level.
Using Pivot Points
The general idea behind trading with pivot points is to look for a reversal or break of the R1 or S1 levels depending on where the market opens.
As mentioned earlier, should the market open above PP, it is considered bullish and you should watch the R1 level for a potential long entry. Ideally, you would expect the market to stall slightly at R1 before moving up to R2, at which point the market should be overbought already and may be a potential exit point. However, should the market have enough momentum, it could break R2 and move on towards R3.
Should the market open above R1 then R2 would be the potential entry and R3 would be the potential exit.
Should the market open below PP, it is considered bearish and you should watch the S1 level for a potential short entry. Ideally, you would expect the market to stall slightly at S1 before moving down to S2, at which point the market should be oversold, making S2 a potential exit point. However, should the market have enough momentum, it could break S2 and move on towards S3.
Should the market open below S1 then S2 would be the potential entry and S3 would be the potential exit.