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Thursday, April 15, 2010

Why stock market, forex and commodity traders use a Pivot Point calculator

What is a Pivot Point anyway? Is a Pivot point calculator of any real use? As a confirmed long-term investor in the stock market, why should I bother about what forex and commodity traders do?

Lots of questions! Hopefully, I'll provide some reasonably cogent answers - in spite of my avowed aversion towards short-term trading. So, first things first. (We'll stick to the stock market since this blog is not about forex and commodities.)

A Pivot Point (P) is a technical analysis indicator used by traders to predict future direction of movement of a stock price (or an index level). It is a price level of a stock (or an index level) that is calculated by adding the previous trading day's high (H), low (L) and close (C) prices (or levels) and dividing the total by 3. In other words:

Pivot Point (P) = (H + L + C)/3.

Some times, a variation of this simple formula includes the previous day's or current day's open (O) price (or level). In which case, the calculation becomes:

Pivot Point (P) = (O + H + L + C)/4.

These formulas are so easy to calculate - why would we need a Pivot Point calculator? That is because we aren't done yet. Calculating the Pivot Point is only the first step. What is its significance?

If on the following trading day, the stock price (or index level) moves above the Pivot Point, it is considered bullish. If it moves below the Pivot Point, it is supposed to be bearish.

To add to the usability of this technical indicator, one needs to add support levels below, and resistance levels above, the Pivot Point. This is where the Pivot Point calculator becomes useful - because all these levels need to be calculated on a daily basis, not only for different indices but for hundreds and thousands of stocks!

The most significant support (S1) and resistance (R1) levels are calculated as given below:-

S1 = 2P - H; R1 = 2P - L

The next important support (S2) and resistance (R2) levels are:

S2 = P - (H - L); R2 = P + (H - L)

Some times a third and fourth set of support and resistance levels are also calculated, but for practical purposes, the Pivot Point coupled with two support levels and two resistance levels are adequate.

In a bull phase, the Pivot Point plus the two resistance levels define the price range (or index levels) above which a trend reversal becomes probable. Likewise, in a bear phase, the Pivot Point and the two support levels indicate a price range (or index levels) below which the bear phase may get terminated.

Do Pivot Points work for longer time frames? Apparently they do - though I've never had the chance or the inclination to use them. For those of you who like to trade daily, understanding the logic behind the support and resistance levels may be important.

I've included two links for those who want to dive deeper into the subject:-

1. http://en.wikipedia.org/wiki/Pivot_point - this link has nice charts

2. http://www.pivotpointcalculator.com/ - a Pivot Point calculator

(Thanks to reader Easwaran for suggesting this topic.)

Related Post

About Support and Resistance levels in stock chart patterns

1 comment:

sreyO said...

thanks for discussing this topic. i'd like to add that many day traders use camarilla trading concept based on pivot point and upto five resistance and support level.
to more about camarilla trading one can visit http://chartschool.wordpress.com/about/