In this guide, I show you how you can use Pivot Points in reversal trading strategy.
Before we go any further, two comments.
- Reversal trading is not for beginner traders. It requires very good risk management, because you open the transaction in the opposite direction of main trend.
- This is just one of many strategies you can use pivot points for. If this type of reversal trading is not your favorite strategy, you can build many others.
Why should you have reversal trading strategies in your trading plan?
They allow you to open a position right at the beginning of a new movement. This has two big advantages:
- You can set stop loss close to the entry. If you aim at reversal move you plan to catch the top or bottom. If you manage to do that, your stop loss can be near that top or bottom.
- Your position may be bigger. Other traders who will be late will have to open smaller positions to maintain risk management. They will probably aim with stop loss below the bottom or above the top to protect their capital. However their entry position will be more distant from yours. This is a big advantage for you!
This is what I mean by that. You can see how with help of Pivots you are able to join the reversal move when it starts:
So, you can catch the beginning of a new wave of movement. This way your potential profits can be really big if you don’t close your position too early.
You do not have to worry about corrections. The problem that traders have is that they enter a trade too late. They open the trade in the right direction, but too late. They start to make adjustments, panic, close the trade. You, on the other hand, can watch the situation calmly.
Here’s a good example of that. If traders went long after breakout and move stop loss to break even after some move up then they would be stopped out.
That is why Pivot Points are the ideal solution here.
Originally they were used to determine the best places to close a position. Back in the 80s floor traders were looking for the best ways to find where to close a trade and take profit.
This is how Pivot Points were born. Support lines determine where to expect strong support and profit taking from short positions. Resistance lines determine where to expect potential resistance and taking profits from long positions.
Currently the use of Pivot Points is much wider than that. First of all, outside the place to close positions they are used to open positions in the opposite direction. Traders know that price reactions at R or S levels can mean the beginning of movement in the opposite direction. Not always, but quite often new waves start from the pivot levels and this is no coincidence.
Add to that trading robots. They also try to use all popular methods used by traders to open and close positions. In the case of robots, it is often not a matter of catching larger movements, but simply looking for places where greater volatility can occur. And this often occurs near important support and resistance, such as Pivot Points.
Here’s an example of my trading robot which is using S levels as targets for short position. You can see example of partial close – so at each important support level robot closes part of trade and take profit:
How to build a reversal trade strategy around Pivot Points – price action
Pivot Points were never intended to serve as a blind target for price. This means that even if we know that S2, S3, R2, R3 levels are very important and there is a good chance that there may be movement in the opposite direction from here, it does not mean that you have to open a trade blindly.
ALWAYS your best friend is price action. No matter what trading technique you use, you can practically always combine it with price action.
It is no different with Pivot Points. Here’s an example of bearish engulfing price pattern at pivot line. That was the moment when new leg down started:
Price action will be the first to give you a hint that a given level of pivot works and move in the other direction is possible.
What to expect with pivot levels
There are three main scenarios possible with Pivots levels:
- Pivots will act as a support for resistance and it will be the beginning of more movement like a bigger correction or a completely new wave
- Pivots will act as a support for resistance, but it will be a temporary correction followed by a continuation towards the original trend
- Pivots will not work and the price will move towards the main trend
There are other side scenarios possible, but the three are the most important ones you will encounter using pivot points.
I have written about this in detail in this tutorial here: Price action and Pivot Point trading – guide/.
Therefore, if the price is approaching significant Pivot levels, you cannot blindly assume only one scenario. You must have a strategy that will confirm that the position should be open at that particular moment.
How to trade with reversals and pivot points
My first advice is to start with price action and basic trend lines. For example, if you see a pin bar near the S2 level and immediately afterwards a resistance line is broken, this is a good signal to open a position:
I would suggest checking how such a combination worked in the past. Start reversal trading with this combination.
If you prefer the signals from oscillators you can also include them in your system. Here, however, it is important to first observe how the price itself behaves near the pivot levels. Only then add the signal from the oscillator.
Divergence is when the price moves in one direction and the oscillator moves in the other. If you combine the divergence that occurs near Pivot Points you can have very good reversal trades:
I particularly recommend divergences based on RSI. There are trading tools that mark divergences on the screen such as RSI, CCI, Stochastic divergence tools for MT4.
I like trading with divergence, but you must remember one thing. Divergence appears quite often. The appearance of a divergence is not a signal to open a position. You have to wait for the appropriate confirmation. In my case it is usually a breakthrough of the trend line.
It is worth noting that reversal moves can start with different pivot lines based on different timeframes. For example, you use 15min time frame with daily pivot points. It may happen that the price will react with the level of weekly or monthly pivot points and this is where the reversal move starts. Therefore it is good to control what happens on other pivots. This is not so time-consuming. For example, in the case of monthly pivot points the price will react with the most important levels several times a month.
Levele S2, S3
Second and third levels S2, S3, R2, R3 are very important and you should keep an eye on them. The price rarely comes close to them and therefore they are often used to close positions and take profit.
Pivot line (the middle one) can also be the place where the reversal move begins. Pay special attention to pivot lines with strong trends. Then, when a reversal appears, it often does not have enough strength to break through to the other side of pivots. Example of that:
This is a situation where two or more levels of Pivots are close together. Of course, we are talking about pivots levels counted in different ranges. For example, R2 from daily pivots and R1 from weekly pivots etc. may be close to each other. That’s our confluence.
Again, it is useful to observe the situation on several time frames. Even if you use daily pivot points on a daily basis, you just want to check what is happening on other pivots.
Money management in reversal trading
The basis for success in reversal trading is good money and risk management. Reversal trades are transactions that you open in the opposite direction to the previous trend. This may turn out to be stronger and return to the continuation of the movement. That is why it is necessary to set a stop loss and to adjust the position size well. A Position Size Calculator like this Posisition Size Calculator for Metatrader 4 is useful here.
To sum up
Reversal trading can be a very good way to catch bigger reversal moves and earn good money. Always the biggest challenge is to localize potential places where this reversal move can start. Here pivot points come in handy. They give you information about potential support and resistance. If you combine this with a good use of price action, risk management and entry signals, you should succeed in reversal trading.