Indicators Mathematical Calculations

MATHEMATICAL CALCULATIONS

Pivot point is a mathematical formula designed to determine the potential range expansion based on a previous time period’s data, which include the high, the low, and the close or settlement price. One reason why I believe in using these variables from a given time period’s range is that they reflect all market participants’ collective perception of value for that time period. In the beginning of the book, I quoted Jesse Livermore: “The patterns the traders and technicians observe are simply the reflections of human emotional behavior” [Richard Suitten, Trade Like Jesse Livermore (Wiley, 2005, p. 70)]. The range, which is the high and the low of a given time period, accurately reflects all market participants’ exuberant bullishness and pessimistic bearishness for that trading session. The high and the low of a given period are certainly important as they mirror human emotional behavior. Also, the high is a reference point for those who bought out of greed, thinking they were missing an opportunity; they certainly won’t forget how much they lost and how the market reacted as it declined from that level. The opposite is true for those who sold the low of a given session out of fear that they would lose more by staying in a long trade; they certainly will respect that price point the next time the market trades back at that level. So the high and the low are important reference points of interest. With that said, pivot point analysis incorporates the three most important elements—the high, the low, and the close—of a given trading session.

THE LEADING INDICATOR     

The definition of the pivot point is the average of the high, the low, and the closing price. Pivot point analysis is mainly used as support and resistance levels. The pivot point is the heartbeat of the analysis; without it, projected ranges and market condition cannot be determined. It does act as a support or resistance level as well. Pivot point analysis helps as a leading price indicator for traders because it gives traders advanced indication of potential highs or lows or, in some cases, both in a given time period, unlike Fibonacci studies, where there is no predicted time period in which a projected price correction or projection will occur. I want to step up the concept so that you can develop a trading system on some powerful setups and on what triggers a trade. As I disclosed, professional stock, forex, and futures traders have had significant success in utilizing these “hidden lines”; and I think that with a more thorough understanding of the concept, so will you.

As a quick review, one of the main benefits for using pivot point calculations is that they help determine when to enter and when to exit positions. As a trader, you already know you can only book a profit when you exit; and if you don’t exit a losing trade quickly, it is hard to maintain, or keep, what you have already made. Pivot points are used to project support and resistance or actual highs and lows of trading sessions. These numbers are derived from a mathematical formula; there are several versions that, for your benefit, I will go into; but keep in mind that I still use the most common method to derive my analysis. Here are the most common formulas:

• Pivot Point—the pivot point (P) is the sum of the high (H), the low (L), and the close (C) divided by three.

P = (H + L + C)/3

• Resistance Level 2—R-2 is the pivot point number plus the high and minus the low.

R-2 = P + H - L

• Resistance Level 1—R-1 is the pivot point number times two minus the low.

R-1 = (P x 2) - L

• Support Level 1—S-1 is the pivot point number times two minus the high.

S-1 = (P x 2) - H

• Support Level 2—S-2 is the pivot point number minus the high plus the low.

S-2 = P - H + L

Some analysts are adding a third level to their pivot calculations to help target extreme price swings on what has occurred on such occasions as a price shock news-event-driven market reaction. It seems that I have noticed that the spot forex currency markets tend to experience a double dose of price shocks because they are exposed to foreign economic developments and U.S. economic developments that pertain to a specific country’s currency. This tends to make wide trading ranges. Therefore, a third level of projected support and resistance were calculated

Resistance Level 3-R-3 = H + 2 x (Pivot - Low) or (P - S-1) + R-2

Support Level 3-S-3 = L - 2 x (High - Pivot) or P - (R-2 - S-1)

There are other variations that include adding the opening range, in which case you would simply find the sum of the open, the high, the low, and the close; and then divide it by four to derive the actual pivot point.

P = (O + H + L + C) /4

One more variation of that concept—to factor in gaps from adverse price moves from one day to the next is to take the previous session’s high, low, and close, add in the new trading session’s open, and then add in those variables and divide by four. In using both open prices, you still calculate the extreme support and resistance levels with the same formulas.

P = (new O + old H + old L + old C) /4

Let’s go over what these numbers mean and how price action reacts with these projected target levels. But first, let me state that I personally do not use the R-3 or S-3 levels because I believe in looking at the progressively higher time period’s price support or resistance projections. For example, from the daily numbers, I would look at the weekly numbers, and then from the weekly numbers I would look at the monthly numbers. The longer the time frame, the more important or significant the data. Also, it is rare that the daily numbers will trade beyond the extreme R-2 or S-2 numbers; and when the market does, it is generally in a strong trending condition, in which case we have methods to follow the market’s flow, which we will cover in the next few chapters. By focusing in on just a few select numbers and learning how to filter out excess information, I eliminate the analysis paralysis from information overload. Do yourself a favor and keep reading because this does get exciting. The following list shows how the numbers would break down by order, what typically occurs, and how the market behaves. Keep in mind that this is a general description. You will learn what to look for at these price points in order to spot reversals so you can become more profitable from trading in the markets.

• Resistance Level 3—Extreme bullish market condition generally created by news-driven price shock. This is where a market is at an overbought condition and may offer a day trader a quick reversal scalp trade.
• Resistance Level 2—Bullish market price objective or target high number for a trading session. It generally establishes the high of a given time period. The market often sees significant resistance at this price level and will provide an exit target for long positions.
• Resistance Level 1 —Mild bullish to bearish projected high target number. In low volume or light volatility sessions or in consolidating trading periods, this often acts as the high of a given session. In a bearish market condition, prices will try to come close to this level but most times fail.
• Pivot Point—This is the focal price level or the mean that is derived from the collective market data from the prior session’s high, low, and close. It is the strongest of the support and resistance numbers. Prices normally trade above or below this area before breaking in one direction or the other. As a general guideline, if the market opens above the primary pivot, be a buyer on dips. If the market opens below this level, look to sell rallies.
• Support Level 1—Mild bearish to bullish projected low target number in light volume or low volatility sessions or in consolidating trading periods. Prices tend to reverse at or near this level in bullish market conditions but most times fall short of hitting this number.
• Support Level 2—Bearish market price objective or targeted low number. The market often sees significant support at or near this level in a bearish market condition and is a likely target level to cover shorts.
• Support Level 3—Extreme bearish market condition generally created by a news-driven price shock. This level will act as the projected target low or support area. This is where a market is at an oversold condition and may offer a day trader a quick reversal scalp trade.

Most of the research and books written on technical analysis cover the topic of trade entry and how to use indicators, oscillators, and moving average studies. Few go over how to target exits. Longer-term traders have read the works done on volume analysis to help determine the strength or the weakness of a trend. There is further information on consensus studies, such as the Commitment of Traders (COT) reports; the VIX, which is a volatility index, is based on calculations using options on the Standard & Poor’s (S&P) 500 Stock Index. Plus, the put-to-call ratio helps give investors an idea if a trend is ready to change. None of these studies actually helps a trader with targeting a potential trading range in a given time period. That information will help a trader with setups and triggers on entering a position and, most important, exiting a position. This is where pivot point analysis will help you.

Think for a moment: If most technical tools are lagging indicators and if most traders follow and use these trading indicators to make trading decisions, then it would make sense that most traders get trading signals and execute entering into a position on a lagging basis or well after a move has been established. Then, if the same indicator gives the exit signal too late, perhaps that is what perpetuates habit or the consistency of losing money in the markets, from entering or exiting later, based on lagging indicators.

Then, in order to adjust getting in too late, traders anticipate a market turn; and more times than not, that turns out to be a bad trading decision. Or traders may decide to just “hang in there” a while longer, thinking that the market may just return and give them back the sweet profits that were just accumulated in the trade. That is a syndrome that many traders tell me they fell victim to. By using pivot point support and resistance levels, you can speed up the analytical process on entries; and by employing certain trade management techniques that we will go over in a later chapter, you can effectively help improve your exits. After all, that is one of the most important aspects of trading. A profit is just a paper asset until a position is offset. The offset relies on an exit strategy. Ask yourself this question: How many times have I been in a trade and thought I was doing the correct thing by letting my winners ride, by holding on to the position only to see my paper profits erode and then perhaps turn into a loss? The flip side to this is: How many times have I taken a quick profit, banked the money, and no more than a few moments later watched the market explode dramatically further in the direction of my original position? Just when you say the market can’t move any further, that’s when it usually does. You need discipline and patience to stay with a trade. These situations will likely happen; but by utilizing pivot points and by watching the market’s behavior at or near these levels, you will be better prepared to make better trading decisions, especially on exits.