Unlocking the Power of Pivot Points - Definition, Formula and How to Calculate

Summary:

A pivot point is a technical analysis chart tool through which you can gauge the support and resistance levels of a stock’s current day’s trading by taking the average of its high, low, and closing price of the previous day.

Determining the general market trend is one of the recipes for success, especially in intraday trading. There are various tools to do so, one of which is pivot point. It’s a technical analysis chart tool through which you can make intelligent trading decisions to boost profits and minimise loss. So what is exactly a pivot point, and how to calculate it? Let’s find out.

What is a pivot point?

It’s a technical analysis chart tool that accounts for the previous day’s high, low, and closing prices to determine the support and resistance level of the current day’s trading. A support level is the price at which a stock tends to find buying interest, which means you can expect more buyers than sellers at this level. On the other hand, a resistance level is the price at which a stock tends to encounter a selling interest, which means you can expect more sellers than buyers.

A pivot point averages the last day’s high, low, and closing price, and the resulting point is the baseline for determining the support and resistance level of current day’s trading.

Formula to compute pivot point

The formula to compute pivot point is as follows:

Pivot point = (High + Low + Close) / 3, where:

• High denotes the highest price from previous day’s trading
• Low denotes the lowest price from previous day’s trading
• Close denotes the closing price from the previous day’s trading

So, if a stock’s highest price on the previous day is INR 100, the lowest price INR 90, and the closing price INR 85, the pivot point as per the formula will be (100 +90+85) / 3, which is 91.6. While the pivot point is one central component of the chart, there are other components, too namely:

Resistance (R1), (R2) and R3), which are above the pivot point

Support (S1), (S2) and (S3), which are below the pivot point (see image below)

Source: Fidelity.com

Trading scenarios in pivot point

Following are the two trading scenarios in pivot point:

• Bounce from support: If a stock’s price is near the support level and shows signs of bouncing, this indicates an opportunity to buy it. However, waiting for some time is prudent to ensure that the price is indeed bouncing.
• Reversal from resistance: If a stock’s price is approaching a resistance level and shows signs of going downward, it indicates a chance to sell and book profits.

Advantages of pivot point

Here are the advantages that pivot point brings to the table:

• Easy to calculate: Pivot points are relatively easy to calculate. All you need to do is take the average of the previous day’s low, high, and closing price of a stock. This simplicity makes it accessible to all traders.
• Risk management: Pivot points help in effective risk management by helping you set stop-loss orders. By placing stop-loss orders below support or above resistance levels can help minimise losses.
• Identifying key price levels: Through pivot points, you can identify crucial price levels at which market activities are likely to occur. You can use support and resistance levels as barriers or turning points for gauging price movements.
• Helpful in intraday trading: If you are an intraday trader, pivot points can be a highly useful tool for you to capitalise on short-term price movements. Through it, you can identify entry and exit points in a single trading day.

Limitations of pivot points

Like any other tool, pivot points have certain limitations. These include:

• Timeframe sensitivity: Pivot points are highly susceptible to the chosen time frame you use for calculation. The same stock can have different pivot points when calculated for daily, weekly or monthly basis. Hence, it’s crucial for you to choose an appropriate time frame based on your trading style.
• Market volatility: Heightened market volatility can result in price gaps that can bypass pivot points. During such times, you must exercise caution as the signals provided may not be that reliable.
• Short-term focus: Pivot points are more suitable for traders with a short-term view. If you are a long-term investor, you may find limited utility of pivot points.
• Lack of fundamental analysis: Pivot points don’t incorporate fundamental analysis or external factors that can influence markets and stock prices such as geo-political developments, news events, etc.

Combine pivot points with other indicators

While pivot points help you make intelligent trading decisions, its effectiveness increases manifold when combined with other technical analysis tools, such as moving averages and oscillators. Their combination helps you get a more comprehensive market view and enhances the chances of successful trades.