One tool that permits us to do all of the above is the pivot point. A pivot point is a predictive indicator of market movement. It is used to determine the significant price levels of a financial market. There are several different methods for calculating pivot points, the most common of which is the five-point system (classic). This system is calculated as an average of significant prices (high, low, close) from the performance of a market in the prior trading period. Generally speaking, the pivot point is seen as the primary support or resistance level. If the market in the following period trades above the pivot point it is seen as a bullish indicator, whereas trading below the pivot point is seen as bearish.
Additional levels are also used above and below the pivot points by calculating price differentials from previous trading ranges of the market. These levels are used to determine a multitude of ceilings (resistance levels) and floors (support level) for the following trading periods, and represent key junctures where the forces of supply and demand meet.
Whenever there is an active trading range, the economic model of price determination is in play. In the financial markets, prices are driven by excessive supply (down) and demand (up). Demand refers to how much quantity is desired by buyers, and is synonymous with buying, bullishness, and resistance levels. Supply represents how much quantity the markets can offer, and is synonymous with selling, bearishness, and support levels. Price is a reflection of supply and demand. As demand increases, prices advance and as supply increases, prices decline. When supply and demand are equal, prices move sideways and are said to be in a state of equilibrium (fair value).
Support and resistance levels derived from pivot points can be used just like traditional support and resistance levels. Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. Although it is uncommon, both support and resistance levels can fail to hold, signaling that the relationship between supply and demand has changed. Usually, this occurs when new information is released or anticipated. A breakdown below the support indicates that sellers have reduced their expectations and are willing to sell at even lower prices. A breakout above the resistance indicates buyers have increased their expectations and are willing to buy at even higher prices. Once a break occurs, the former level becomes the inverse of itself (a break below support, confirms a new resistance level; a break above resistance, confirms a new support level.)
Being aware of price action in relation to key support and resistance levels, can greatly enhance a trader's analysis and forecasting abilities. A useful rule of thumb to remember:
- If the price of a financial market approaches an important support level while buying pressure has increased, a potential bullish reversal might occur.
- If the price of a financial market approaches an important resistance level while selling pressure has increased, a potential bearish reversal might occur.
The example above is a simple strategy I devised using a few technical indicators in relation to pivot point crossovers. The strategy uses a five-point system to identify a crossover (either through a pivot point, or one of it's derivatives.) As seen above, the buy signal was initiated right after a resistance level was broken and buying pressure exceeded it's 3-month exponential moving average. A relative strength indicator was used to determine if the purchase price was overbought or undersold. In the case above, the RSI confirmed that the security was undersold while above a resistance level (this gave more merit to the previous buy signal.) The sell signal was initiated when a support level was broken, and the active selling pressure exceeded it's 3-month exponential moving average.
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