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THE CHARTIST


Pivot Points, Stop Losses, & Buy-Stops

02/10/06 11:02:04 AM PST
by Rudy Teseo

They go together like mini-wheats, milk, and bananas.

What a market does when crossing pivot points is a good judge of the overall market trend. Prices crossing above the central pivot indicate a bullish trend and vice versa for prices crossing below the pivot point. What is a pivot point? The definition depends on whom you're asking. There are pivot points that are derived from a formula involving the high, low, and close of today's prices. Some analysts define pivot points as the turning points at peaks and troughs. Investor's Business Daily refers to pivot points as the tick above the center spike of a double bottom, or the tick above the high of the handle in a cup with handle. The first of these is objective: there's no confusion as to the result of a formula. The next two may be subjective: there could be argument as to the exact price of the pivot point, especially since pivot points change minute by minute.

IDENTIFYING PIVOTS
I'll confine myself to the first definition. There are actually five formulas. They define the pivot point (PP), the first support (S1), the second support (S2), the first resistance (R1), and the second resistance (R2). These are the formulas:


PP = (H+L+C)/3 (a simple average of the three prices)
S1 = (2*PP) - H
S2 = PP-H+L
R1 = (2*PP)-L
R2 = PP+H-L

Figure 1 is a portion of my portfolio analysis (PortAnal) spreadsheet showing the values of these points alongside each security. Note the position of PP midway between S2 and R2. You can see why PP is sometimes referred to as the fulcrum. We see from our charts that Apple Computer (AAPL) has been in a steady upswing. One of Value Line's rules is to buy when a stock hits a new high. But it's a bit pricey here, so what's a good entry strategy?

Figure 1: Spreadsheet showing pivot point values for each security (PPSS.XLS).

Well, with support and resistance levels defined, this is as good a picture of tomorrow's probable boundaries as you will find. If the price at the opening is above the PP, indicating an upward continuation, you could enter long at the market. However, some hedging might be desired. You could place a stop-loss at S2 ­1. This would protect against the stock breaking through the second support line, and still give a one-dollar cushion in case it hits but bounces off the support line.

If you're willing to give up a few points on the buy side for a little assurance, you could place a buy-stop at R2+1. The reasoning is that if it breaks through resistance, it'll keep going. Again, the one-dollar cushion guards against buying if the price hits R2 and bounces back. The one-dollar cushion wouldn't apply to all stock prices, and should probably be adjusted accordingly.

PIVOTS ON YOUR SPREADSHEET
Here are the formulas for the spreadsheet showing the conversion to cell designations:


PP = cell M12 (C12+D12+E12)/3
S1 = cell L12 (2*M12) ­ C12
S2 = cell K12 (M12-C12+D12)
R1 = cell N12 (2*M12) ­ D12
R2 = cell O12 (M12+C12-D12)

If you would like to duplicate this spreadsheet, you will have to have a data source that includes the high, low, and close. The open does not enter into the equation. Note that you cannot use this for mutual funds, as most funds only report end-of-day closing prices. If you change any of the first 10 columns, you will have to change the cell references accordingly. However, if you construct the spreadsheet as shown and then make your changes, the cell references will change automatically.

Figure 2 shows these values used to plot custom indicators. The PP was omitted to reduce the confusion. Here you see the support and resistance points very clearly. This pattern gives you a picture of the four values rather than a tabular one.

Figure 2: Chart of AAPL with pivot points plotted as custom indicators.

Here are the plots in MetaStock. This may help you in plotting custom indicators in your charting program. In MetaStock, PP was made a function, and thereafter it was pasted into the plot logic, which saved a lot of typing and avoided possible typos:


PP = (H+L+C)/3 (this then becomes the function Fml ("PP")
S1 = 2 * Fml ( "PP") ­ H
S2 = Fml ( "PP") ­H + L
R1 = 2 * Fml ( "PP") ­ L
R2 = Fml ( "PP") +H ­ L

Note: These formulas were pasted in from MetaStock, so this is exactly how they appear.

One problem you might have accepting these values is that S2 may be too tight for your investment style. If you have been using a standard 7% stop-loss, some R2s may only be 3-4% below PP even with the added dollar. If you do a little tweaking, you can make the percentage any value you want. I have found that doubling the value of H and L in the formula for S2 changed a 3% difference to 5%. You can have fun with this.

If you've come this far, perhaps you'll go one step further. There are alternates to the formulas that give different results. One variation is to add the opening to the PP formula and then divide by 4. Another is to substitute yesterday's close with today's open. Then there's the addition of a third support and resistance where S3 = S2 ­ H + L and R3 = R2 + H ­ L. A suggestion: This might be worth adding if you'd like a wider range between PP and support for your stop-loss. Be aware, however, that these ranges are not fixed. With a wide-ranging day between the high and the low, you could find the percentage difference between PP and R3 to be 20-30%.

If you haven't been using pivot points, perhaps you're not aware that floor traders and daytraders use pivot points to keep abreast of changes in support and resistance levels. If it's good enough for professionals, why not give it a try? It will give you a new way to look at your charts.

BY ANY OTHER NAME
For an excellent discussion of pivot points, see Dennis Peterson's Working Money article, "What Are Pivots?" In it, Peterson refers to the pivot points as "high pivot" and "low pivot." In Charles Drummond's How To Make Money In The Futures Market — And Lots Of It, he introduced what he referred to as "isolated highs" and "isolated lows," respectively. And in his oft-referenced book New Concepts In Technical Trading Systems, J. Welles Wilder called these points "high points" (HIPs) and "low points" (LOPs). All these terms refer to the same price patterns. So, a rose by any other name...

Rudy Teseo is a private equity, options, and currency trader, and has taught classes in option trading and stock charting. He can be reached at rftess@juno.com.

SUGGESTED READING
Drummond, Charles [1979]. How To Make Money In The Futures Markets — And Lots Of It, Drummond Publications.
Peterson, Dennis D. [2002]. "What Are Pivots?" Working-Money.com, February 19.
Wilder, J. Welles [1978]. New Concepts In Technical Trading Systems, Trend Research.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.





Rudy Teseo

Rudy Teseo is a private investor who trades stocks, options, and currencies. He has taught classes in technical analysis and option trading. He may be reached at rftess@optonline.net.

E-mail address: rftess@optonline.net


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