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Creating a Trade Plan Using Pivot Points
One strategy that I learnt from Richard Kang during the Asia Trader and Investor Conference is on the use of pivot points to create your trade plan. This is a very simple trade plan that doesn’t require much monitoring of real time charts.
Before I go into the plan, let me first explain what a pivot point is.
A pivot point is a technical price indicator that is derived from the numerical average of the low, high and average price. Here’s the formula for calculating the pivot point:
Pivot point = (Previous high + Previous Low + Previous Close) /3
This indicator is used to predict the price direction for the next time frame and also to calculate the support and resistance level. The formula for calculating the support and resistance is as follows:
Resistance 1 = (2 x Pivot Point) – Previous Low
Support 1 = (2 x Pivot Point) – Previous High
Resistance 2 = (Pivot Point – Support 1) + Resistance 1
Support 2 = Pivot Point – (Resistance 1 – Support 1)
Resistance 3 = (Pivot Point – Support 2) + Resistance 2
Support 3 = Pivot Point – (Resistance 2 – Support 2)
Depending on the time frame you are going to predict, the respective low, high and closing prices will be used for the calculation.
For example, if you use the day’s low, high and closing price to calculate the pivot point, it can be used to predict the next day’s direction. If you are using the week’s data, then the week’s low, high and closing price will be a prediction for the following week’s price instead.
Richard mentioned that he prefers to use the weekly pivot points when he is trading stocks as a day’s data might have too much noise. For my forex trading, I prefer to use the daily pivot points. Remember a day in forex is 24 hours – this is almost 3 times the trading hours for the stock market.
Now that you know how to determine the pivot points, let’s move on to the trade plan.
The trade plan is extremely simple. The closing price is compared to the pivot point to predict the price direction.
- If the closing price is above the pivot point, go long for the next trade. Buy only if price dips and hits the pivot point. Conversely, if the closing price is below the pivot point, go short for the next trade. Short only if price rises and hits the pivot point.
- If you are long (after condition 1 has been triggered), take profit with a limit order set at R1. Stop loss level is just below S1. If you are short, take profit with a limit order at S1. Stop loss is just above R1.
As you can see from the trading rules, this plan is very simple to execute. It is purely mechanical with not much inputs or judgements required. Let’s look at one example. These are the latest daily pivot points of EUR/USD based on Friday’s close, high and low.
High 1.5958
Low 1.5711
Close 1.5814
R3 1.6192
R2 1.6075
R1 1.5945
Pivot 1.5828
S1 1.5698
S2 1.5581
S3 1.5451
The closing price is 1.5814, which is below the pivot point of 1.5828. Therefore, I will be looking for a short trade for the day.
If the price goes up to 1.5828, I will open a short position with a stop loss near R1 (1.5945) and limit order near S1 (1.5698).
The risk/reward ratio is 127:130 which is roughly equal. If you think it’s not good enough for you, you can alwasy choose to skip the trade. As it turned out, this trade will result in the stop loss being hit with a loss of 127 pips.
Some modifications to the basic plan might be possible. For example, if the closing value is very close to the pivot point, you might want to use R1 or S1 as the entry level instead. If that is the case, the stop loss and limit order will have to be shifted.
Based on the same example, I will use R1 as my entry level. R2 will be my stop loss and S1 my limit order. One characteristic of using this plan is that you will enter into trades much less often.
Another way is to use the pivot point in conjunction with the technical charts to detemine the exit prices.
No matter how you tweak the plan, be sure to test it out to determine the best strategy for yourself.