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Pivot Points are a timeless classic. They date from an era when trading was done on the exchange floor. Traders did not have calculators or computers. They needed simple yet relevant price points at the start of every session and based on the official price (open, high, low, close) published by the exchange they day before. These price points became know as the Pivot Points.
Over time different types and different ways to calculate Pivot Points developed. Yet every trader should be able to do a classic Pivot Points analysis.
The Pivot Points are used to identify support and resistance levels.
First the main Pivot Point (PP) is calculated. The PP is the average of the high, low and close. It is also known as the typical price. Based on the PP three support levels and three resistance levels are calculated (S1, S2, S3 and R1, R2, R3).
Another powerful concept is the Pivot Range. It was originally used by floor traders. The main Pivot Point is the mid-line of the Pivot Range. The top of the range is called the Central Pivot Point (CP). The CP is based on the previous period´s mid-line. The CP is mirrored around the PP. This is the bottom of the Pivot Range. This price level is called the Directional Pivot (DP).
This diagram shows a classic basic Pivot Points analysis.
Initially the PP, the CP and the DP act as support and resistance. If the market price drops back to the Pivot Range it is not unlikely a reversal will occur.
If the previous period was a balancing period, the main Pivot Point and the Central Pivot are close together i.e. the Pivot Range is narrow. A narrow range means indecision. If the previous period was an up-trending period, the Pivot Range will be wide. If the range is wide (which means the previous period was a trending period) traders expect a balancing period for the current period. It is therefore likely that the DP will be hit, when price tries to explore the new value area between the previous period´s close and the PP of the current period.