Option Investor
Trader's Corner

Pivot Points and other Things to Consider

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It doesn't matter what a markets deals in - stocks, cows or widgets - they exist to facilitate trade, nothing more, nothing less. As such, in order to enhance the exchange process, prices will continually fluctuate between supply and demand. Markets detest a stand off, they cannot exist in a state of paralysis so are in constant motion caused by market traders adjusting bid and ask prices to keep the exchange going. As the price moves up, it brings in more buying or, as the price moves down, it brings in more selling.

As the market moves up the up move brings in selling. The selling is a response and firstly shuts off the buying and secondly causes the market to reverse and move down. The result is the up trend ends and a down trend begins. But what if the market moves up and the response is not selling but more buying? The market has to continue to move higher to bring in an opposite response - selling and a reversal. But until that equilibrium is reached the up move will remain "out of equilibrium" and continue to move up.

The same thing happens when the market moves down and brings in buying. The buying is a response and firstly shuts off selling and secondly causes the market to reverse and move up. The market will continue to move up until equilibrium is found.

These equilibrium points are the upper and lower boundaries of a range and markets will trade between the established equilibriums until a new equilibrium is reached above the high or below the low thus creating a new range and new equilibrium points. These equilibrium points of course are called support and resistance and are coveted by all traders. The market is always either in equilibrium or working towards it.

I would now like to explore what causes the equilibrium points to shift or move up or down and to do that I need to explain that market activity is divided into two categories: short-term activity and longer term activity or other time frame activity.

The majority of trading in a day is done by floor traders or "short-term" traders. These short-term traders constantly move prices up and down to these areas of equilibrium - aka support and resistance, exploring the narrow limits of equilibrium. Trading for the day will stay between this narrow range unless "outside" buyers and sellers (longer-term traders) are attracted to the price action. If the narrow range of support or resistance established by the short-term traders can be thrown off balance then off floor longer term traders will be attracted and enter the market, as buyers if short term resistance is overcome or as sellers if short term support is violated. These breakout points then usually reverse their function and serve as test points, i.e. previous resistance becomes support and previous support becomes resistance.

The current range of trading expands as the longer term traders enter the market because of an event whether it be a surprise event or a scheduled event. Better yet the current range of trading expands as the longer term traders enter the market because of their "perception" of an event not so much the event itself. If established support and resistances can be successfully broken then more long term traders will join the fray and continue to throw the market out of equilibrium. This will continue until an opposite response is elicited and equilibrium is once again achieved.

Let's take a minute and look at the events that will bring longer term traders into the market that in turn throws it out of equilibrium and breaks through resistance or support. All events that affect equilibrium fit into three basic categories:

* surprise events
* unlikely events
* likely events.

And each one has a different effect on the markets. Broadly speaking, surprise events have a short-term impact, unlikely events have an intermediate-term impact and likely events have a long-term impact.

  1. A surprise event - or the perception of what the surprise event means - will cause current price to move sharply in one direction then back again. The event doesn't usually have a fundamental impact on price at least right away so market participants react immediately and then reassess as they consider the longer-term implications. The capture of Osama Bin Laden would be a surprise event that would throw the market out of equilibrium until the market participants could assess what impact this event will have longer term, if any.
     
  2. An example of an unlikely event is a CPI report that made a dramatic rise instead of falling like the analysts had predicted. The result is very much like a surprise event because market participants react immediately and price is thrown out of equilibrium until they have time to assess the news. The longer the participants take to assess the longer price will stay out of equilibrium. But unlike the surprise event that initially has no fundamental impact on longer term value, the unlikely event does have an impact on longer term value.
     
  3. 3. A likely event usually has no impact on the market because it has already been discounted but definitely does have an affect on longer term value.

To recap you know that support and resistance areas are areas when the market has returned to equilibrium and that events will throw price out of balance because these events will bring in the longer term positional traders that are not interested in trading the market from one area of equilibrium to another like a short term trader is.

Now if you knew the range boundaries of support and resistance used by short term traders you would have a way of knowing when the significant areas where longer term traders may try to take the market. The short term traders calculate these range boundaries from the previous day's high, low and close.

The calculation for the new day are calculated from the High (H), low (L) and close (C) of the previous day.

Pivot point = P = (H + L + C)/3
First area of resistance = R1 = 2P - L
First area of support = S1 = 2P - H
Second area of resistance = R2 = (P -S1) + R1
Second area of support = S2 = P - (R2 - S1)

So if there has been no significant market event you can expect the short term traders to take prices to test the near term support and resistance and the pivot price. If these near term support and resistance areas fail then the second such area will likely be tested. If we have a surprise, unlikely or likely event the second area of support or resistance could fail and the long term positional players will likely enter the market and start a market trend.

These pivot points are areas you should take note of and respect for they can be both perilous and areas of opportunity. Perilous because the floor traders "sweep" these points looking for stop orders as they swing up and down the pivot points. However, if you correctly identify support or resistance it can offer a low risk entry point with a close stop loss point identified.

Even if you are not a day trader, knowing the key pivot, support and resistance points can help the longer term positional trader identify potential entry points and stop loss levels for a trade if other criteria have determined the direction in which you should be trading.

Calculate your own pivot points or use the ones that OI posts each and every day as the areas of support and resistance. Study the next day's price action in the context of those pivot points so that you get familiar with the dynamics of the market.

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