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The Pivot and the Three-Day Pivot

Posted By Doug Tucker On September 18, 2007 @ 4:11 pm In | Comments Disabled

In my commentary I often make reference to the three-day pivot indicator on my daily charts. This indicator helps give me a bias as to what side of the market to trade from, a point of support or resistance, and a point where a short-term trend change could be indicated. This indicator gives me a rough guide. I do not take signals from this indicator. It is not a trading system. It is just a point of reference.

Before describing this indicator, I would like to clear up the definition, in trading terms, of a pivot. There is some confusion among traders, as there are two common uses of the term.

The most common definition is: a pivot is a price level that stands out on the chart as a high point and surrounded by lower bars, or for downtrends, a low level that stands out and is surrounded by higher bars. For example, in an uptrend, a price level will be reached that attracts selling and shuts off buying, at least momentarily. Prices will usually fall back somewhat, thus leaving a price bar on the chart that has lower highs on either side. This high price bar then becomes an area to test on the next push higher. Most often technicians require two lower highs on either side of the high bar (or in the case of a downtrend, two higher lows on either side of a low bar). Some technicians require three lower highs on either side, while some prefer an asymmetrical pivot with two or three bars to the left with only one bar to the right of the high bar. If you have trouble visualizing this, just look at the fingers of your hand. The middle finger is the longest, with two lower fingers on either side. Thus, the middle finger represents the pivot bar on the chart.

tdp1.png
In the above chart you will see green dots on the high pivots, and red dots on the low pivots. I set the dots to paints only after the second lower high to the right of the pivot bar, in the example of the green dots, or second higher low to the right, in the example of the red dot. Keep in mind that these dots don’t paint until two bars late, so they are useless to pick out the pivots in advance. But after they paint, they do offer excellent areas for prices to test. I have my software set to draw a series of horizontal dots extending to the right after a pivot is created, as shown by the darker red and green lines of dots extended from the actual pivot dot.

You can see that the pivots on the left side of the chart tested both the upper and lower levels several times. The lower tests held, and could be considered successful tests. The upper pivots were penetrated, but on the first two tests the penetrations failed and prices were sent back to test the lower levels. The third test was successful and overcame the pivot, and prices moved higher. A series of low pivots were also created, but not tested until the red dot near the high, which was tested and failed to hold, and prices quickly moved right back down. It is important to view prices and a series of tests, thus forming a market structure depending on the resulting success or failure of each test. Pivot points on the chart create excellent reference points to interpret the developing market structure.

Some traders refer to these pivots as swing points. Those who view the markets in terms of chaos theory would refer to them as fractals. They are all same concept, just with different names. I have a few more examples in my article on Trend Determination [1].

The other use of the term pivot is unrelated to these swing points. It is a term that has been used for many years by floor traders to come up with a reference point based on the prices from the previous day.

tdp2.png
The above chart is a thirty-minute day-session Dow Mini Futures contract. Displayed are three days worth of data. The thick yellow line is the floor trader pivot. It is simply the average of the high from the previous day, the low from the previous day, and the close from the previous day. The result of this calculation is usually referred to by technicians as the typical price. The typical price is then plotted as a straight line across the intraday bars on the current trading day. The cyan and red dashed lines are support and resistance calculations based on the typical price.

The formula for all five lines is as follows:

Pivot =(H + L + C)/3
Resistance level 1 =(2*P) – L
Support level 1 =(2*P) – H
Resistance level 2 =(P – S1) + R1
Support level 2 = P – (R1 – S1)

I personally find these levels quite useless for trading. Some people think that these levels have meaning because so many floor traders, and now screen based traders, watch them, and they become self-fulfilling. That may be true to some degree. I had to look over many days of data to find the example above that displayed some of the characteristics traders look for. You can see on the first day, on the left side of the chart, that prices found support and resistance at the cyan dashed line, but the yellow pivot wasn’t of much use. Then on the next day, in the middle of the chart, prices open at the pivot and then made a directional move away from it, but neither support level provided any useful information as prices slid right past them. Prices did find resistance at the pivot early the following day, and then proceeded down to the first support level, and then rallied back up to the pivot. On most trading days there is no useful information at any of these levels. Many attempts have been made to change the formula, such as using the current day’s opening price instead of the previous close. There is little improvement with any of these alterations, in my opinion.

An interesting experiment is to draw a line randomly on an intraday chart. Just close the eyes and drop a line using a horizontal line tool, and place it anywhere on the chart. Then watch as prices move away from or toward this line. It will hit and reverse on the randomly drawn line about the same percentage of times as it does off the pivot or the support or resistance levels. The randomness of the placement of the line does not necessarily make it useless. A line drawn anywhere on the chart can be a useful point of reference. With a line on the chart one has a better sense of the market movements. You can more easily gauge the movement, or acceleration toward or away from this line. It is similar to being in a boat at night, in a fog, with a lighthouse in the distance. The lighthouse becomes a point of reference, and you can tell whether you are getting closer to or further away from that point of light.

As much as I find the floor trader pivot to be of little value, I do find the three day average of the pivot to be a useful. And I have little use for the support and resistance levels often used with the floor trader pivot.

tdp3.png
The above chart shows the three-day pivot as yellow dots on the daily chart of the QQQQ. The three-day pivot is simply the three period simple moving average of the typical price, or more simply, the three day average of the average of the previous highs, lows, and closes, and plotted on the next, or current bar.

tdp7.pngWhen the market is in a trend, prices tend to push away from the yellow dots, and the dots are usually moving in the direction of the trend. When prices move too far away from the dot there is a tendency for a retracement back to the dot, and as long as the dot is still advancing in the direction of the trend, the trend is still intact. The chart to the left shows an unusually persistent uptrend in the Dow ETF. Notice the smooth progression of advancing dots, with only a couple small back ups in the advance. There were very few closes below the dots. Reversals back above the dots were followed by further advances in price. Also, notice when prices advances very far from the dots, there was a tendency for the price bar and the dot to come back closer together. The amount of excursion away from the dot is simply determined from experience.

tdp8.pngThe chart to the right shows an unusually dramatic sell-off. Trading from the side of the three-day pivot kept the trader on the correct side of the market on nearly every bar on this chart. On the day of the big sell off, prices opened far below the three-day pivot, then rallied back up to it but couldn’t get through it. Then prices started back down, and extended down into a large range bar with a close near the low. Notice on the fourth bar after the big plunge that the opening price was far away from the dot, and how price rallied, almost to the tick, back up to the dot, and then fell away to close to a new low for the day. The following day the opening price was right on the three-day pivot, and prices advanced throughout the day. The reverse was true on the last bar on this chart.

tdp9.pngAs the dots flattens and prices trade on either side, and usually with overlapping price bars, it can be assumed the market is chopping sideways with no discernable trend. The chart to the left shows a very choppy, sideways pattern, with many overlapping price bars. However, if you look closely, the three-day pivot kept the trader on the correct side of the market on many of the bars, at least on a very short term basis. There were several large range bars that opened near the dot, and then extended away from the dot in a directional move. There was one notable large range bar to the right side that opened far above the dot, and then reversed and extended far below it, thus transversing the three-day pivot. In this case there was follow through over the next three days. Be aware of failures of the three-day pivot to hold, and for prices to go the other way. Failures can also give valuable clues. Nothing is perfect. This indicator is just a guide, not a trading system.

tdp6.pngAs stated earlier, often the price will open near the dot, and then extend away from it and close on the opposite end of the bar. This, in my opinion, is one of the best uses of this indicator. The chart to the left offers several excellent examples of this. If a market had been in congestion, a move away from the three-day pivot could result in a trend day. It can be particularly powerful to watch for narrow range bars followed by large range bars, especially if it is the narrowest range bar out of the last seven or more. After a narrow range bar, or a series of narrow range bars, expect a large range bar to follow, as volatility can be quite cyclical. In such a case, trading on the side of the three-day pivot will often be the correct side to trade on. On the chart to the left I have red crosses marked on bars that are the narrowest of seven bars, or often known as NR7 days. Notice on the first and last bar marked with the red cross there was a substantial move on the following bar. (The red crosses only mark the existence of the NR7 bar, not the predicted direction.) The middle red cross had a decent move the following day, but not nearly as dramatic.

The three-day pivot is far from a perfect indicator. It is just one tool to use out of the many that are available. It is important to know when to use the appropriate indicator for what you are trying to accomplish. I find moving averages, whether of closing prices or typical prices, to be useless for generating trading signals. But they can be useful for support and resistance. I find regression curves far superior to help determine trend direction. Therefore, the only moving average I find useful is the very shortest, which in this case is a three period, and using the typical price gives a bit of additional smoothing as opposed to using just the closing price. Some longer-term traders might experiment with a longer moving average

There is a trading approach called Drummond Geometry that uses the same three-day pivot under a different name, and they have the name copyrighted. I’m not certain they can copyright a simple moving average of the typical price any more than I could copyright a 20 period exponential moving average that is in common use. I would assume they only have the copyright on the name. You can Google Drummond Geometry if you want to research their approach further. The have many more examples of this indicator on their web site. I have no opinion on their approach. I was using the three-day average pivot long before I knew of them.


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[1] Trend Determination: http://tuckerreport.com/articles/trend-determination/

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