Pivot points are a very widely used indicator which creates support and resistance levels on a trading chart.  These levels to indicate where reversals (i.e where the price action turns ) or breakouts are likely to occur.

The powerful feature of pivot points is that they do not require interpretation or personal judgement in their calculation.  As a result they are objective so you can be confident that many other people are watching the same levels and just like Fibonacci levels  they become a self-fulfilling prophecy.

Calculation of pivot points is fairly simple mathematically.  The pivot points are calculated using the previous day’s session’s open, high, low and close.  Typically most people use the New york session since forex is a 24 hour market.

Pivot point (PP) = (High + Low + Close) / 3

First resistance (R1) = (2 x PP) - Low
First support (S1) = (2 x PP) – High

Second resistance (R2) = PP + (High - Low)
Second support (S2) = PP - (High - Low)

Third resistance (R3) = High + 2(PP - Low)
Third support (S3) = Low - 2(High - PP)

Using pivot points to trade

In everyday life a pivot is a point where something turns.  In the case of forex, the thing that turns, or at least is expected to turn, is the price movement.  The price is expected to reach the pivot point, turn around and reverse.  This is exactly how we set up support or resistance levels in the first place except with pivot points we calculate where these levels are before the price gets there to turn around.

A little refresher from our lesson in support and resistance levels:

Support and resistance levels are important since they show a price point that the market as a whole is reluctant to break through and so it becomes more likely that when the price reaches that point again there is a much higher probability it will not break through again.   As a result they many traders use them to make trading decisions.

Once broken through, these levels are also where breakouts are likely to occur.

If the price action moves down towards a support level, you would place your buy orders just above the level, ready for the price to come back up and with a stop loss below the level in case you are wrong.  The more confident you of the reversal, the closer you would put the stop loss below the level.  The target for take profits would be set at the next pivot point or resistance level

Just like regular support or resistance levels, levels set by pivot point calculations wont hold permanently so they are used by traders to as areas to watch for breakouts to indicate a strong price movement.

In addition, the pivot point (PP) is also used to judge general market sentiment where price trading above the PP line is seen as bullish and price action trading below the line seen as bearish

As with most indicators Pivot points should be used in conjunction with other trading indicators to make a decision since despite being objectively calculated, without further information it can still be tricky to judge whether the level indicates a good area for a reversal or a breakout .

Elliot waves, like Fibonacci levels, are another example of using patterns that occur frequently in nature to predict the movement of the forex market.  Elliot waves use fractal patterns and like fibonnaci levels, fractal patterns occur frequently in nature.  Fractals are patterns where part of the pattern is similar to the whole creating an increasingly detailed pattern based on a simple self-repetition.  Common examples are fern leaves where a fern leaf is made up of smaller leafs that look like the whole, which again is made of smaller leafs.  Snowflakes and coastlines are frequently quoted as examples of self-similarity.

Since the forex market is governed by the psychology of millions of human investors buying and selling currencies the market as a whole.  According to the Elliot wave theory the crowd psychology of the forex market moves between periods of optimism and pessimism in predictable waves.

The Elliot wave model  predicts that the market will move in sets of “impulsive” waves, which form the main trend, followed by a set of corrective waves.  The main impulsive wave itself will be broken into a set of smaller impulse and corrective waves.

The 5-3 wave

The first set of implusive waves is comprised of 5 waves.  These waves are numbered 1 -5 as below.

The corrective wave is comprised of 3 waves.  These waves are labelled with the letters ABC.

Elliot wave rules

There are 3 rules to correctly count Elliot waves

1 Wave 2 cannot retrace beyond the start of wave 1

2 Wave 3 cannot be the shortest wave

3 Wave 4 cannot overlap in the same price territory of wave 1

Wave timelines

The timeframes of Elliot waves are called degrees.  The shortest of which occur on a minute to minute scale.  The completed set of 5-3 waves on the minute scale would comprise the first wave and correction (i.e wave 1 and 2) on the next degree up ( the hour degree).  Once this set completes it would comprise the start of the 5-3 wave of the next degree up and so on ad infinitum.

These degrees have been labelled

Grand supercycle: multi-century

Supercycle: multi-decade

Cycle: one year to several years

Primary: a few months to a couple of years

Intermediate: weeks to months

Minor: weeks

Minute: days

Minuette: hours

Subminuette: minutes

Fibonacci and Elliot waves

Given that Elliot waves rely on the patterns created by mass crowd psychology, it shouldn’t be very surprising that there is an overlap with Fibonacci retracement patterns.  Fibonacci retracement levels  are often used with Elliot wave theory to predict the size of corrective waves as corrective waves frequently bounce off Fibonacci retracement levels.

Flags and pennants are two similar consolidation patterns which can signal a continuation of the previous trend.  They are formed when a steep trend is followed by a generally sideways movement.  Once a breakout occurs, quite often the resulting movement continues the previous trend just as steeply.

Flags

The flag pattern is formed when the price moves between two parallel trendlines after a steep trend.  The flags trendlines are usually not horizontal and are usually in the opposite direction of the initial trend.  The signal to buy or sell comes when the price breaks out of the flags channel in the direction of the initial trend.

Pennants

Pennants are very similar to flags however pennants differ in shape in that the trendlines of the pennant converge into a symmetrical triangle rather than remain parallel such as in a flag pattern.

It is essential that the movement prior to the flag or pennant is very steep (almost vertical) for a flag pattern to be identified.

Flags or pennants can occur during a downtrend or an uptrend.

Like other chart patterns discussed previously, the target of the breakout should be set around the same size as the size of the prior movement before the flag or pennant pattern.

Rectangles occur when the price moves between two parallel horizontal support and resistance levels.  The rectangle pattern is a continuation pattern that occurs midway during a trend.   The price moves quite strictly between the two levels forming the rectangle.

The rectangle usually indicates a continuation of the pattern so during an uptrend it usually indicates the price will move up once it breaks through the upper level or during a downward trend it most likely will breakout downward.  It should be noted that while rectangles usually signal a continuation they can represent a period of indecision as well as consolidation so it is possible that a reversal can occur.  This is also the reason that in order to trade a rectangle pattern you should wait for a convincing breakout through the support/resistance levels before entering the market.