Pivot points are key areas at which price action may experience reversals. They are usually derived from the high, low and closing prices of the previous day’s price activity. Previously these values had to be recalculated every new trading day, but the process has now been simplified by the use of pivot point calculators. These are software that are attached to the charts as custom indicators, and they plot the pivots automatically.
Pivot points can also be used to trade price breakouts. In this case, pivot points will serve as the upper and lower boundaries of price action, and these will serve as the limits through which the price action can breakout to the upside or downside.
The daily pivot points are the subject of this discussion, and we will demonstrate the breakout trade using pivot points.
The two indicators to be used in executing this strategy are:
- Daily pivot calculator (used in plotting the pivot points automatically)
- Coloured MACD indicator
The Strategy: Fundamentals of the Breakout Trade
There are seven commonly used daily pivot points: S1, S2, S3, R1, R2, R3 and the central pivot point. The pivot point that is central to the breakout trade is the central pivot. This is because the position of the price action relative to the central pivot point determines the bias for the day. If the price is above the central pivot when trading opens for the day at 10pm GMT, then we look out for a bullish breakout scenario. If the market opens below central pivot at 10pm GMT, then we look for a bearish breakout scenario.
Once the bias for the day has been established, the next step is to use the central pivot and the pivot point nearest to it (R1 for bullish-biased trades and S1 for bearish-biased trades) as the boundaries for the breakout. When the price action eventually breaks out of one boundary, use the principles of the breakout trade to make the entry and use the next pivot point in the path of the price action as the profit target, while setting a stop loss below the broken pivot (long trade) or above the broken pivot (short trade).
The breakout is simply defined by the price action breaking above a pivot point and closing above it, or breaking below a pivot point and closing below it. For this strategy, the breakout is defined by price breaking and closing above R1, or price breaking below and closing below S1.
1) Long Trade
The long trade is taken as follows. When the price action opens for the trading day above the central pivot point, the bias for the day is taken as bullish. We wait for the price action to break above the R1 line. Usually the price action will attempt a pullback to R1 after it has been broken. If this happens, you can do either of the following.
- Use a Market Buy order to enter LONG at R1, if you are watching the market on your computer directly.
- You can also use a Buy Limit order when the pullback is occurring, setting the entry price as the R1 price.
Pivot Breakout: Long trade setup
The stop loss for the trade is set at a few pips below the R1 line. This must not be more than 10 pips because if price retreats below R1, it may head all the way back to the central pivot. You do not want your trade dragged all the way down with it. Keep your stops tight.
The Take Profit point is set at R2 as the first target. If R2 is broken, use a trailing stop to attempt to follow the price all the way to R3 while protecting the unrealized profit from the trade.
2) Short Trade
When the price action opens for the trading day below the central pivot point, the bias for the day is taken as bearish. We wait for the price action to break below the S1 line. Usually the price action will attempt a pullback to S1 after it has been broken. If this happens, you can do either of the following.
- Use a Market Sell order to enter SHORT at S1, if you are watching the market on your computer directly.
- You can also use a Sell Limit order when the pullback is occurring, setting the entry price as the S1 price so that a successful pullback will trigger the trade.
Pivot Breakout: Short Trade Setup
The stop loss for the trade is set at a few pips above the S1 line. This must not be more than 10 pips.
The Take Profit point is set at S2 as the first target. If S2 is broken, use a trailing stop to attempt to follow the price all the way to S3 while protecting the unrealized profit from the trade.
Please note that this trade should only be taken when the market opens between the central pivot and either R1 and S1 for bullish and bearish trades respectively.