A pivot point is a crucial turning point in the price of a stock or security that a lot of traders tend to trade around.
It’s basically a price at which the stock stops going up or down and reverses in the opposite direction. It’s the price at the foremost extreme of a rally.
Pivot points can only be accurately identified after the fact, as you need to have price action following the pivot point to know if it’s actually a pivot point.
How to Find Pivot Points?
There are two views on pivot points in trading: technical and discretionary.
Finding Pivot Points Through Quantitative Means
The technical definition of pivot point defines a pivot point very clinically:
- A pivot low is a price bar (candlestick) at which both the prior and subsequent lows are higher than this bar’s low.
- A pivot high is a price bar (candlestick) at which both the prior and subsequent highs are lower than this bar’s high.
While the technical definition and use of pivot points is useful for creating indicators and scripts that automatically identify pivot points as they crop up, it’s very noisy, you get a ton of pivot points which aren’t actually pivot points.
For this reason, most traders who employ pivot points as part of their methodology opt to identify pivot points through a mix of automated and discretionary means.
Most charting packages will have built-in indicators that automatically identify pivot points. Often they’re simply called “Pivot Points,” with the points being marked with labels like “S1” and “R1,” signifying support and resistance.
Another great source for pivot points are indicators that identify periodic highs like Donchian Channels, which allow you to plot bands around price that plot a periodic high, most commonly 20 and 50 day highs, but experiment.
For example, let’s take a look at some pivot points generated by the TradingView “Pivot Points – High and Low” indicator in Apple stock (AAPL):
Finding Pivot Points Through Discretionary Means
For practical purposes, a pivot point is simply a local extreme in price action that represents a short-term reversal.
Identifying these extremes doesn’t have to be a rigid and systematic process. It can be as simple as marking off the most obvious turning points on the chart.
An exercise that we love and will mention further in this article is to print out a blank chart and start marking off the obvious pivot points. Do this repeatedly and make it a habit. When you’re analyzing a chart on your computer, simply use a drawing tool from your charting platform to mark off the obvious pivot points you see on the chart. Afterwards, compare your results with a quantitative measure like a pivot points indicator. You’ve definitely missed some meaningless pivot points, but look out for any significant pivot points you might have missed.
Why Use Pivot Points?
Support and Resistance
A lot of people talk about support and resistance but don’t really have a practical explanation for why it should or does work. Oftentimes it’s quite hand-wavy. Learning to identify pivot points and watching the price action around them can give you a much better understanding of the fundamentals of support and resistance.
Ultimately a support or resistance level is a point at which either supply or demand becomes imbalanced. At support, an imbalance of buyers comes in and buys aggressively, which quickly pushes the price away from the support level.
Pivot points represent shifts in the market; they once served as points of imbalanced supply or demand and hence, have a high probability of doing so again. The stock market is made of human traders, and human traders have a memory of recent significant trading levels and will alter their trading activity around these levels.
One of the best reasons to become familiar with pivot points is because they often serve as significant points of support and resistance.
Swing Analysis
Swing traders mostly try to take one little “swing” out of a price move, rather than playing for the long-term trend. Many of these swing traders will spend their time analyzing the cyclical nature at which upswings and downswings form in a stock, and pivot points are a key factor to that.
One simple but powerful exercise involves marking several pivot points on a chart and then connecting them to each other, forming a series of upswings and downswings. You’ll often find that you’ve revealed a rhythm to that stock’s price action that wasn’t previously apparent. The rhythm of the swing cycle was hidden by all the random price noise.
Trend Analysis
At its most basic, a trend is a series of higher highs and higher lows, or lower lows and lower highs. These highs and lows that you use to analyze a trend are, most of the time, pivot points in themselves.
For this reason, you can use your pivot points to analyze a trend in a different way. Rather than looking at tools like moving averages or oscillators like the Average Directional Index which give you an idea of the “slope” of the trend, pivot points give you a mechanical reading of what’s actually happening.
Oftentimes a stock can have a significant upward or downward drift in one direction without actually establishing a trend pattern on the trading time frame. In other words, the moving averages and oscillators might tell you something is trending and is a buy, while a more rigorous analysis of the pivot points might show that the trend pattern was broken several bars ago.
A great example is below in $XLE the energy stocks ETF:
The 50-day moving average screams “strong trend,” while the price action around the crucial pivot points tells a different story. The pivots are marked in black arrows, and as you can see the price started to stall around the highest pivot high in November, continually failing to break to highs, before eventually making a lower pivot low and breaking the trend pattern.
Bottom Line
If you get one thing out of this article it’s that levels like pivot points tend to provide more reliable support and resistance levels than those that look like “traditional” support and resistance levels which are levels that price visits several times.
Pivot point analysis is very simple conceptually but actually using it to make money is a different story entirely. As we always warn, it’s crucial not to fall victim to shiny object syndrome and add in tools like pivot analysis to your trading toolbox until it has a very specific use and reason for its role within your trading system.
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Original source: https://www.warriortrading.com/pivot-points/