Tips on Technicals - Pivot Points
By Michael N. Kahn
For any market, there is an equilibrium point around which trading activity occurs. In the absence of large numbers of new buyers or sellers, this point serves as the pivot or focal point for floor traders (locals) and market makers as they adjust their bids and offers. When prices move away from the pivot, there are zones of support and resistance that can be derived from the established value area in the market. Penetration of these zones leads to perceived changes in valuation and the entry of new players into the market.
The pivot point and its support and resistance pairs are defined as follows:
where H, L, C are the previous day's high, low and close, respectively.
Trading for the day will usually remain between the first support and resistance levels as floor traders make their markets. If either of these first levels penetrated, off-floor traders are attracted into the market. These breakout levels then usually reverse their function and serve as test points, i.e., previous resistance becomes support or previous support becomes resistance. The range of trading has expanded and if a second support or resistance level is breached then longer term traders will be attracted.
The valuation parameters used by floor traders can be calculated with the simple formulas above. Knowledge of the levels at which different types of traders enter the market can help in determining when a shift in valuation by the locals has occurred. This is especially useful when there is little outside influence on the market and trading is dominated by the locals.
As long as no significant market news has occurred between yesterday's close and today's opening, locals tend to move the market between the pivot point and the first band of support and resistance. As with traditional technical analysis, should these levels fail then the second levels will come into play. If this next support and resistance band fails then a new influx of players will come in and likely start a trend in motion.
Floor traders regularly take the market up and down within their value range so orders placed within it are likely to be executed. This can cause a problem as whipsaws can occur. However, by placing stop orders outside this range it is more likely that a trend emerging from the local "noise" of the market can be captured.
Knowledge of the pivot point set can help non-locals, as well.
If prices move to the first resistance level and one or more of your other technical indicators has moved into overbought territory, the confirmation provided creates a higher confidence sell signal. However, if prices reach the first resistance level and your other indicators are still in a bullish mode then you can make a higher confidence buy with an upside target of the second resistance level.
The chart above shows 5 days of tick data for the August 1997 COMEX gold contract with two sets of pivots. Each set is drawn over the day the pivots were calculated and extended into the next trading day. As can be seen, the support and resistance levels provided approximate targets for the market in each case. For June 18, the early market drop occurred on minor news. The rest of the precious metals complex was under pressure that spilled over into gold. Later, when the second support level was broken, the market fell apart.
Pivot points have a large following with floor traders. However, tick charts show that these levels do not always provide meaningful signals. They should be used as part of a complete set of technical tools but never after market moving news or in active markets.
Michael N. Kahn is a columnist for Barron's Online based out of Florida. He also writes a free technical newsletter. The complete collection of Michael Kahn's "Tips on Technicals" is available in Real World Technical Analysis.