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Chapter 9: Pivot Points – Part 2

5 Mins 03 Mar 2025 0 COMMENT 7 LIKES

In our previous chapter, we explored the concept of pivot points. These points serve as crucial price discoverers, calculated from the previous trading session’s high, low, and closing prices. They offer valuable insights into market sentiment, aiding traders in identifying potential support and resistance levels for the current trading session.

First, let's delve into some fundamental aspects of Pivot Point Trading:

Pivot points are labelled "objective" due to their calculation method using precise mathematical formulas from previous price data. These calculations generate consistent support and resistance levels, ensuring uniformity across traders.
Wide pivot ranges indicate heightened volatility, prompting adjustments to trading strategies.
Narrow pivot ranges suggest lower volatility, offering opportunities for scaling positions using support (S1, S2) and resistance (R1, R2) levels.
The central pivot line serves as a point of equilibrium between buyers and sellers, representing an intraday balance, and thus offering optimal risk and reward opportunities.

Did You know?

Pivot points have an intriguing connection to geometry. Their name originates from the geometric concept of a pivot, which is a central point around which something rotates or oscillates. In trading, pivot points serve as central reference points for price oscillations, guiding traders in navigating market rotations with precision.

1. Basic Pivot Point Strategy

At the heart of pivot point trading lies a simple yet powerful strategy: buy in uptrends and sell in downtrends around the central pivot point. This strategy leverages the central pivot point's significance as a point of balance between buyers and sellers, providing clear entry and exit points.

Market Direction Assessment

Traders assess the overall market direction by analyzing whether the price is trading above or below the central pivot point.

A price trading above the central pivot point suggests a bullish bias, while a price below the central pivot point indicates a bearish bias.

Entry and Exit Points

In an uptrend, traders look for buying opportunities near the central pivot point or support levels (S1, S2, S3).

In a downtrend, selling opportunities are sought near the central pivot point or resistance levels (R1, R2, R3).

Traders set profit targets at the nearest support or resistance level, depending on the direction of the trade.

Stop-loss orders are placed below support levels for long positions and above resistance levels for short positions to limit potential losses.

Traders adjust position sizes based on the distance to the nearest support or resistance level and their risk tolerance.

As you can see in the above 2-hourly chart of Axis Bank, the stock is in a clear downtrend, with prices consistently trading below the central pivot points (P) (black lines).

You can identify the shorting opportunities as the price retraces towards the central pivot point or resistance levels (R1s) (blue lines). The central pivot point acts as a key resistance level, providing a favourable entry point within the context of a downtrend.

Profit targets are set at support levels (S1s) (orange lines) or based on previous swing lows, where price action suggests potential support. You may also employ trailing stop-loss orders to capture additional gains as the downtrend progresses.

Here, the downtrend started after breaking through a big consolidation phase with a string bearish candle. However, even after the breakout, the price tested the central pivot point but failed to breach it, forming the start of a strong downtrend. You may enter at this point (marked with a green arrow), with a stop loss at the previous swing high. The first profit target is set at S1, you may liquidate the entire position here or partly liquidate with a trailing stop loss set at again at the previous swing high.

As you can see the downtrend ends after the price breaks the central point with a gap up and with a strong green candle. However, one should wait for the price to trace back to the central point, but as this is a strong breakout formation, the price moves to an uptrend now.

2. Combining Pivot Points with other indicators

1) RSI & Pivot Points

RSI measures the magnitude of recent price changes, providing insights into overbought or oversold conditions. When integrated with pivot points, RSI can offer valuable confirmation signals:

Divergence Detection: Bullish or bearish divergences between RSI and price action can serve as early warnings of potential reversals. When these signals align with pivot points, traders can anticipate key reversal levels with greater accuracy.

Confirmation of Pivot Breakouts: RSI can validate breakout moves above or below pivot points. For example, if the price breaks above the pivot point accompanied by RSI surpassing the 50 level, it reinforces the bullish bias, guiding traders in their decision-making process.

Let’s try to understand using an example:

Identify a bullish divergence between RSI and price action. A bullish divergence occurs when the RSI indicator shows higher lows while the candlestick chart displays lower lows—a sign of potential upward momentum.
Wait for the price to break above the upper pivot level, signalling upward momentum.
Look for a pullback to the pivot line, indicating a potential entry point.
Set stop-loss levels below the pivot point based on risk tolerance. It can be set at the first support level (S1) or at the previous swing low.
Take profits at the next resistance levels and keep a trailing stop loss at the support levels or the swing lows.

Conversely, in a strong uptrend scenario, traders can exploit bearish divergence to anticipate potential reversals and optimize entry and exit points.

2) Combining pivot points with MACD, and EMA

The fusion of pivot points, MACD (Moving Average Convergence Divergence), and EMA (Exponential Moving Average) presents a potent framework for identifying high probability trading opportunities and managing risk effectively.

The MACD indicator capture trend momentum and adds depth to our strategy. Its histogram provides visual cues regarding the strength and direction of price movements, enabling traders to gauge market momentum with precision.

EMA, with its focus on recent price data, acts as a reliable indicator for confirming trend direction. By smoothing out price fluctuations, EMA offers clarity on the prevailing market sentiment, thereby validating trading decisions.

Understanding the Strategy

Look for instances where the price is above the 50-period EMA, indicating an uptrend.
Confirm bullish momentum with the MACD histogram above the zero level.
Validate the bullish bias by observing the price trading above the pivot point, signalling potential upward momentum.
Enter long positions as the price breaks above the pivot point, coinciding with MACD and EMA confirming bullish sentiment.
Set stop-loss levels below the pivot point to mitigate downside risk.
Take profits at the next resistance levels or based on predefined reward targets.

In the above daily chart of ITC, we observe the stock lingering around the 50-EMA for an extended period before finally surging above both the 50-EMA and its central pivot points. Concurrently, the MACD histogram transitions to a bullish green (above 0). While this presents a potential entry opportunity for a long position, exercising caution by awaiting a pullback is prudent, especially given the subsequent whipsaw movement. Setting the initial target at the next resistance level (R1) above the 50-EMA, with the stop loss placed at either S1 or the previous swing low, is advisable.

Given the robustness of the uptrend, profit-taking and implementing a trailing stop loss are recommended strategies. Subsequently, targeting the next R1 with a stop loss marginally below the prior R1 level, which now acts as support, enhances risk management. It's noteworthy that despite a slight consolidation phase, the stock remains positioned above both the 50-EMA and the central pivot point, indicating a lack of bearish signals. As the stock breaks out of this consolidation, resuming its ascent above the central pivot points and accompanied by a green MACD histogram, it underscores a strong continuation of the uptrend.

Summary

Pivot points serve as critical price discoverers, derived from the previous day's high, low, and closing prices. They provide insights into market sentiment, guiding traders in identifying potential support and resistance levels.

The width of the pivot range reflects market volatility. Wider ranges suggest higher volatility, prompting adjustments to trading strategies, while narrower ranges indicate lower volatility.

Positioned as the intraday balance between buyers and sellers, the central pivot point serves as a pivotal reference for trading decisions, offering optimal risk and reward opportunities.

Buying in uptrends and selling in downtrends around the central pivot point forms the core of a basic pivot point strategy. This approach leverages the pivot point's role as a point of equilibrium to identify entry and exit points.

Integrating pivot points with indicators like RSI, MACD, and EMA enhances trading strategies. These indicators offer confirmation signals, validate breakouts, and provide insights into trend direction, enabling traders to make informed decisions.

In the next chapter, we will learn about Value Area Trading, which leverages market profile analysis to identify key price levels within a trading session based on trading volume distribution.

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