Pivot Point Trading for forex and futures

Before computers and ADP equipment, pivot points were used by floor traders on equity and futures exchanges as a simple way to forecast the direction of the market during the day. Despite often being included in historic trading strategies, pivot points are still used by Forex traders to determine support and resistance levels. According to Jamie Saettele, senior currency strategist at Forex Capital Markets LLC, pivot points actually work very well in Forex markets because of the large size of the market, especially when used with very liquid pairs.

Pivot points basically provide a trader with reference points. These points help to determine when to enter the market, place stops and exit. Each point basically supplies a support or resistance level. The pivot point and levels are calculated based on information from the previous day.

There are several different ways to calculate pivot point and levels. In fact, there are eight different formulas for just calculating the pivot point. Different methods include the Woodie, Camarilla and Tom DeMark pivot points. The simplest formula uses the High, Low and Close from the previous day. There are three levels of resistance, the pivot point and three levels of support.

Calculations are made as follows:

To determine the actual pivot point:

Pivot Point = (High + Low + Close) divided by 3

The first resistance and support levels are now calculated:

Resistance 1 = (pivot point times 2) – Low
Support 1 = (pivot point times 2) – High

The second resistance and support levels are calculated:

Resistance 2 = (R1 – S1) + pivot
Support 2 = (R1 – S1) – pivot

The third resistance and support levels are calculated:

Resistance 3 = [2 times (pivot-low)] + high
Support 3 = [2 times (high - pivot)] + low

There are a select few analysts who actually go as far as adding a fourth level of support and resistance, however this often becomes a bit esoteric for trading purposes. There are also ways of tracking the mid-points between each level.

The pivot point on a day with an high of 1.2297, a low of 1.2213 and a close of 1.2249 would calculate to be 1.2253. Using the pivot point, we then set our support and resistance levels. They will go from top to bottom on the chart as follows:

R3 = 1.2477
R2 = 1.2337
R1 = 1.2293

Pivot point: 1.2253

S1 = 1.2209
S2 = 1.2169
S3 = 1.2125

The best way to fully understand how pivot points work is to actually do the math yourself, looking at the forex charts. Using the EUR/USD, calculate your pivot points, support levels and resistance levels. You will notice that the trading range for the session you are looking at will usually occur between R1 and S1, with the pivot point being at the center of the movement. The majority of breaks will occur around one of the market opens. At this time there is an influx of traders entering the market.

There are many different strategies to use pivot points, including the combination of identifying candlesticks with pivot levels. For example, if prices are trading below the pivot point, but then break above the pivot while forming a doji, the trader might sell short because of the expected drop back below the pivot point.

The pivot point can also be used to validate the strength of a movement. For example, the price breaks the pivot level, reverses and then trends back towards the pivot level. It then moves through the pivot point. This could indicate that the pivot level is not very strong. However, if a price hesitates around the level for a period of time, the pivot may be more significant. A future move towards the pivot point may actually be a break, indicating future movement.

Pivot points are also used to judge the probability of a move. For example, analysis shows that between the inception of the Euro on October 12, 2006, the actual low has been lower than the average S1 44% of the time. A trader my put a stop below S1 with confidence, based on probability. However, this information is generally more useful as a support tool to limit risk, combined with other types of analysis.

In general, there are a few tips to keep in mind when it comes to using pivot points:

When a price opens at a certain level, it will generally move to the next level on either side. For example, if it opens at pivot point, it will move back to R1 or S1. If it opens at S2, it will move to S3 or S1.

When there is no significant news or events to influence the market, the price will usually be confined between R1 and S1.

Significant news can drive the price to R3 or S3.
R3 and S3 are usually the maximum ranges for extremely volatile movement during the day. But they are just an estimation, not a certainty.

In a strong trend, the price will go straight past a level without any hesitancy at that point.

Many different types of traders use pivot points as a key part of technical analysis. Technical indicators, such as pivot points, help traders to identify levels of support and resistance. They help to identify moves that can be considered as breakouts and where the maximum and minimum ranges of movement will occur. Understanding the turning points provide an investor with the ability to make educated transaction decisions. Pivot points can be used with many trading strategies, making them a simple and useful tool for trading.

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Trading the Illogical Oil Bench mark Spread

The two most widely used and traded crude oil bench marks are West Texas Intermediate (WTI) (to be delivered at Cushing, Okla.) and Brent (delivered at Brent in Europe). WTI crude is the U.S benchmark and used for 40-50% of the world’s crude oil. Brent crude is made up of different types of crude oil found in the North Sea. Brent is the European benchmark for 50-60% of the world’s crude. Both of these crude oils trade as futures on the Nymex and the ICE. The crude at both places are comparable: Both are light, low sulfur crudes, with WTI slightly more favorable for gasoline production, while Brent Blend favors diesel production.

Spread Between WTI and Brent

One of the most widely traded and followed spreads in the crude oil complex is the WTI-Brent spread. WTI typically trades at a premium to Brent, reflecting its superior, lower-sulfur composition and also the additional cost of shipping crude to the U.S. The New York benchmark is normally $2.50-4.00 more expensive. The spread is mean reverting with MRL quite near zero for different time periods. Currently the spread has widened to the level which is two standard deviations below normal and is likely to revert and overshoot on the other side. The statistical probability of this reversion is 95%, and on seven of the last eight occasions, the spread reversed from the extreme level.

Drivers of Spread

WTI has historically traded at a premium to Brent in a normal market. Current WTI 0il futures in New York are below London’s Brent benchmark, as inventories at the U.S. delivery hub dropped on higher inventories but may recover on expectation of a crimp of fuel demand in Europe on slower growth. Crude oil on the New York Mercantile Exchange rose as much as 31 cents above Brent yesterday. The spread is affected by several drivers:

1. Crude oil inventories: The single most compelling driver is the level of crude oil inventories in the United States PADD 2 (Cushing, Okla. is a subset of PADD 2 and the Nymex delivery location for WTI) or midwest area. When crude oil inventories in PADD 2 are increasing, the WTI/Brent spread normally decreases and may even turn negative, as has been the case over the last 18 months. When inventories are declining, the spread normally will turn to a premium in the favor of Cushing, as it did in the second and third quarters of 2007.

These are both very pronounced and long-term moves, but when looking at the chart closely, the relationship also exists even during periods when inventories increase or decrease by a much smaller amount than the large movements previously mentioned. From both a financial trading and physical crude oil pricing perspective, the optimum trade had been to be short WTI/long Brent for the last two months or so. But that strategy seems to have run its course. Crude oil stockpiles in Cushing will decline as U.S. demand for gasoline typically surges during the summer driving season.

2. Refinery runs: During the last two weeks of February, crude oil inventories may start to decline in the PADD 2 region of the United States as improvement in refinery runs may slowly begin to eat away at the crude oil overhang. In February, OPEC produced and exported about 4.2 million barrels per day less oil than it did in September 2008, and any hiccups in supply will be positive for WTI prices and spreads.

3. Driving season: With a pick-up in gasoline use in driving season that begins with the May 31 Memorial Day holiday -- a period of high consumption in the U.S. -- the spread balance between WTI and Brent shifts in favor of WTI, as increases in gasoline use in the U.S. are higher compared to EU / emerging markets. It is expected that the WTI discount to Brent will narrow / reverse in March / April. The relationship will change if supplies in Cushing, the delivery point for Nymex futures contracts, start to decline.

4. U.S. dollar and euro outlook: Lately there had been some divergence between WTI price and the U.S. dollar trade-weighted index which shows underlying strong sentiment. Notwithstanding that, the trade-weighted U.S. dollar had been a significant historic predictor of WTI oil price. Also, we expect the U.S. trade-weighted dollar to keep its structural slide against major currencies after some blips. That is only the path of least resistance for crude oil price, and is likely to be positive for WTI price. While a high stock level traps WTI, the decline in the dollar index may result in relative strength in WTI.

5. Europe versus U.S. growth: Higher GDP growth rate in the U.S. compared to the EU should also be supportive of the WTI leg of the spread. The U.S. economy has been estimated to grow by 3.3% in 2010 and Japan's GDP to increase by 2.4% in 2011. U.S. gross domestic product will grow 2.6 percent this year and 2.1 percent in 2011, per IEA estimates. IMF has also predicted OECD to grow by 2.6 percent in 2010. It is also estimated that U.S. households will spend an average of $986 between October and March to heat their homes, an increase of $24, or 2.5 percent, from last winter, per the EIA Winter Fuels Outlook. U.S. WTI consumption is estimated to climb another 0.11 million barrels to 19.08 million in 2011. For the EU, the IMF has reduced its 2011 outlook from 0.2 percentage point to 1.3 percent.

The spread started between WTI and Brent is expected to narrow, as stockpiles in Cushing may decline and concerns may grow that European growth will be slow in the coming months. Because of the European debt crisis, demand in Europe might be affected -- and that would affect prices of Brent oil more than WTI. Oil demand among European members of the OECD will also increase this year, according to the International Energy Agency.

6. Relative expansion of monetary base in the U.S. and the EU: The second round of quantitative easing (QE2), and the fact that the interest rate will remain low and longer than the markets' expectation (meaning probably through 2012, instead of 2011), will be positive for WTI. Such policy typically will further weaken the U.S. dollar, while pushing up prices of dollar-denominated commodities such as WTI, which could lift the spread. The European Union has announced a bailout plan worth almost $1 trillion, in addition to the €110 billion ($135 billion) of aid to Greece to help ward off a slowdown caused by the region’s debt crisis. Europe was forced to bolster rescue measures for Greece and other debt-laden economies in the region. Euro fiscal expansion is deemed to be positive for Brent oil prices, but less so compared to WTI because of a gap between quantum and efficiency of response.

7. Fiscal and monetary tightening in China and East Asia: Further rate hikes in emerging Asia and China should weigh more on Brent compared to WTI. Although the government has implemented a series of measures, including increasing RRR and raising margins for certain commodity futures, the impacts on inflation are not significant. Any further tightening in Asia will be supportive of the spread as the Fed stays on its course of loose policy.

8. Equities markets correlation: WTI prices are more closely correlated with equity indexes, which are rebounding, while Brent reacts more to supply and demand, as noted by Commerzbank’s Weinberg Report. The expectations of good performance by U.S. equity markets in 2011 may result in a relative out-performance of WTI compared to Brent. The decline in stockpiles at Cushing may lead to a narrowing in the discount of prompt crude oil contracts versus those for later delivery, or a contango.

Risks to Spread Trade

One of the risks to the idea is that China’s economic growth is becoming increasingly dependent on meeting its rapidly growing demand for oil from both domestic supply and foreign imports. China’s net crude imports in 2010 totaled a record 275 million tons, or roughly 5.9 million barrels per day, and imports are believed to make up roughly 55% of its total oil consumption. Increasing oil demand is not only attributable to increased vehicle use in the world’s largest new car market, but also to industrial activity. Electricity demand in China grew 22% in 2010.

A recent International Energy Agency report suggests that China may now be the top global energy consumer as well. In 2007, Chinaannounced an expansion of its crude reserves into a two-part system. Chinese reserves would consist of a government-controlled strategic reserve complemented by mandated commercial reserves. The government-controlled reserves are being completed in three phases. Phase one consisted of a 102 million barrels (16,200,000 m3) reserve, mostly completed by the end of 2008. The second phase of the government-controlled reserves with an additional 170 million barrels (27,000,000 m3) will be completed by H1 2011. This implies an additional import of 0.5 million barrels per day in 2011.

Zhang Guobao, the head of the National Energy Administration, stated that there will be a third phase that will expand reserves by 204 million barrels (32,400,000 m3) with the goal of increasing China's SPR to 90 days of supply by 2020. The planned state reserves of 475 million barrels (75,660,000 m3), plus the planned enterprise reserves of 209 million barrels (33,298,000 m3), will provide around 90 days of consumption, or a total of 684.340 million barrels (108,801,000 m3). In total, it may require an additional 2 million barrels per day on top of China’s regular imports, which may tighten the Brent crude oil markets even further.

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