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Take a Two-Dimensional Approach: A Sophisticated Look at

[Editors note: One of the first things that a novice technical trader often learns is the basic
pivot point formula. That, of course, simply involves adding the days high, low and close and
dividing it by three to determine the pivot point. From there, and with a few more minor
calculations, one can pinpoint the first and second support and resistance points. While floor
traders have been using this simple and basic formula for decades, in this article author John
Seckinger adds a slightly more sophisticated twist to the use of simple pivot points.]

For many years, floor traders on the Chicago commodity exchanges have been calculating
levels of support and resistance via a simple, yet effective pivot point formula. The formula
outlined below recently has entered into the mainstream and has quickly become a favorite
among many individual traders. The question is, Are traders really using these pivot levels
properly? Most of them are not.

There are a number of ways that novice traders err in using pivot points as a trading strategy.
One example is that many people believe that the most profitable trade must simply begin by
buying or selling at the pivot point and then exiting at either the daily second support or
second resistance level.

Also, many retail traders simply rely on daily pivots in isolation. But this article outlines a more
powerful trading strategy, which combines the use of both daily and longer-term pivots. This
combination can pinpoint more significant and effective trading levels and can help identify
more potentially profitable opportunities. Before diving deeper, lets first take a look at the
basic formula for pivot points.

Yes, You Can Use a Calculator

How are these pivot levels calculated? Its really very simple. To begin, the daily pivots use the
high, low and close from the previous session and all available data (think: overnight
activity). To take it a step further, weekly pivots are simply the high, low and close of all
trading sessions from Monday to Friday, with Fridays settlement used for the closing figure
and extending the same concept out for the monthly pivots.
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A Confluence Increases Significance

On Monday, a trader could calculate both the daily and weekly pivots. There often will be
confluences when comparing the weekly and daily S2 to R2 levels that increase this areas
significance (see Table 1). Additionally, generally there is a good chance that the high or low
of a given week also will occur on the last trading day of the week, and then these confluences
become even more pronounced at the start of a new week.

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Make Your Own!

A trader could compile a table similar to the pivot matrix following the completion of a calendar
week, and could easily begin to draw conclusions for Mondays session. To begin, notice the
1174 and 1040.50 levels within the matrix in Table 1 the highest and lowest numbers
calculated from using the pivot formula. These levels should represent the very ends of the
multi-timeframe bell-shaped curve, signifying emotional price extremes.

Wondering how to interpret these numbers? Because the E-mini S&P 500 contract closed at
1108.25 on Friday August 27, 2004, a confluence of prices above is in red and will represent
resistance, while support confluences are noted below in shades of green. Weekly S1 also is
noted because of its strong influence during any trading week, especially on Monday. An
observant trader also would observe that the Weekly R1 lines up well with Daily R2, thus
representing the best potential for a selling opportunity to begin the week. If prices fall,
traders would look for a bounce at the statistically significant levels of 1107 and from 1103.50
(rounding to the nearest quarter, since the E-mini futures trade in quarter-point increments) to
1104.50.

The Tricks of the Trade

While many individual traders often think about entering at the pivot and then playing the
move towards the outside of the curve, professionals think otherwise. Novice traders need to
take a different approach in order to achieve better the profitability they may have been
missing.

As prices get inefficient by trading at the outside part of this curve (Figure 1), it is almost
always more profitable to (a) look for a range-bound market instead of a trending session
because a greater percentage of days are range bound, and then to (b) exit at the pivot as
most traders are looking to initiate trade and volume picks up.
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So lets take a look at how a trader might put these numbers into play via some actual trading
ideas. As a general rule, if the market produces a nice trend on Monday, the odds of being
range-bound during the next trading session between Daily S1 and Daily R1 rises
tremendously.

Another good rule of thumb if the market is very quiet and traders are awaiting an important
earnings or economic release, is to look for the Daily R1 and S1 levels to hold and for the
market to work its way back to the daily pivot. Most retail traders are under the impression
that a move outside of these Daily R1 and S1 levels signals breakout; however, this generally
isnt the case. It does, however, mean that floor traders are losing their leverage, and more
participants are most likely involved (read: greater volume), but this breakout typically can be
found about once a week and is surely the low-odds trade.

Get Some Perspective

With a trader looking to either get short at Daily R1 or long at Daily S1, the next question will
be, Wouldnt it make sense to see where these daily levels are in the big picture? If a trader
looks at the bigger picture and sees that Daily R1 is actually on the outer edge of a longer-
term playing field of risk, wouldnt that be helpful?

For example, what if Daily R1 was at 1100 and Weekly R1 was actually at 1098 wouldnt that
help in evaluating risk? Absolutely, because the example explains how a move to Daily R1
would put prices even more to the right on the bell-shaped curve and make it clear that
traders are becoming more emotionally active. Because of this extra advantage, focusing on
the idea of longer-term pivots and their effectiveness is a must for any trader looking to
increase odds of success.

Take a look at the weekly levels now. The magnitude of importance is greatly increased when
looking at a weekly timeframe. Heres an important general rule: There are extremely good
odds that the entire weeks price action will be contained between Weekly R2 and Weekly
S2. Putting that rule into action, lets say that the market moves significantly on Monday into
either the Weekly R1 or S1 level. The odds of a trader making money by either going long at
Weekly R1 or short at Weekly S1 and playing the trend instead of the range is low.

Remember...Weekly R2 and S2 Are Tough Limits

For the Market to Crack

If a trader waits until a move above Weekly R2 to go long or below Weekly S2 to go short,
good luck. This very, very seldom works. Why? As seen in Figure 2, most weeks simply cannot
gather enough strength to extend outside of the Weekly R2 and S2 range. However, traders
should shift their focus to either going short at Weekly R1 or long at Weekly S1 with an
objective of the Weekly Pivot; this can be a viable swing trade strategy. Another twist on that
strategy would be to go long at Weekly S2 and short at Weekly R2 with an objective of Weekly
S1 or R1.

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Further dissecting Figure 2, a trader can see that these weekly levels held significance week in
and week out. Looking at the first week, Weekly S1 held, and then as prices closed back above
the weekly pivot, a trader should have been prepared for a move to Weekly R1. The next
week contained prices from Weekly R1 to Weekly S1; notice how Weekly S1 remained intact
and once again acted as a floor during the week of trading. If Weekly S1 or R1 doesnt contain
prices, wouldnt it be important to know where Weekly R2 and S2 are to manage risk? Of
course, as this S2 level proved extremely valuable twice during the nine-week
illustration. Despite the pick-up in volatility, a trader using weekly pivots will certainly have an
advantage of knowing exactly where the professionals are looking.

Whats Your Size?

Now lets add one other important component of trading position size. If a trader can
understand that the path of least resistance is lower via trend analysis and simple technical
analysis techniques, wouldnt it then make sense to sell more contracts on a failure of Weekly
R1 versus looking to buy on a test of Weekly S1?

Dont fall into the trap of just buying five or selling five E-mini futures no matter what. An apt
analogy might be a trader who bets exactly the same amount that a football team would score
on a play from their opponents one-yard line or their own one-yard line. Take the time to
adjust your position size, according to the odds of the overall trade.

With that said, when the E-mini trades Weekly R1 on Monday and the trend remains bearish,
think of being on the opponents one-yard line with a very strong bunch of front lineman.

Dont Forget about

Money Management

Be patient, and use strict capital preservation techniques if you are a swing trader. Keep your
stop-loss in place until the E-mini contract moves four points in your direction. Then move
stops to breakeven while looking to take profits at the weekly pivots. If eight points is
achieved and the pivot is not yet reached, evaluate market conditions and consider taking off
half of the position. Moreover, move stops down to capture a four- point gain, and then
reward yourself for trading with the same strict discipline as running a business. Then relax.
 If one is a day trader, he could look to move stops down to breakeven on a two-point gain and
then take half the position off at four points (or daily pivot, whichever is reached first), all
while moving stops down to ensure a gain of two points. The maximum objective would also
be eight points.

Readers should be aware that we cannot in good faith make it seem as though taking eight
points or more out the E-mini futures contract is easy. It isnt. Trading is hard, and if you are
looking for a system that takes 20+ points a day out of a contract, this article may not be
appropriate.

Rely on the Line in the Sand

As almost all futures traders realize, there are almost always more range sessions than
trending days, and being able to take emotions out of the equation and fade the general
populous will be the profitable strategy more often than not. If the market is in an uptrend
and prices pull back significantly to start the week, most amateurs will get nervous and
liquidate long positions as soon as a chart support position is barely taken out and volume
picks up. Then we get our test of Weekly S1 and look to take advantage of the amateurs
emotions.

Its clearly obvious that better traders trade with zero emotions. In fact, with most traders
unable to effectively draw support and resistance lines, pivots work well because they
generally become the de facto line in the sand. Program trading will, of course, have orders
either exactly on or right around these levels, while amateurs once again will do the wrong
thing as the above-mentioned Weekly S1 support level is taken out and emotions peak.

We, however, relax, take a deep breath, and then wait for a small confirmation of support to
go long.

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