One of many ways to profit in the buying and selling of financial instruments is trading in foreign currencies. Also called “foreign exchange” (or “forex” for short), currency trading can be as lucrative for the experienced day trader as trading in ordinary stocks.

To understand the foreign exchange market, consider this simple example. If I wanted to acquire 100 British pounds, it may cost me $200 to buy them. Later in the day, I might be able to sell those same 100 British pounds for $204 because the market for that currency rose during the day for obscure reasons.

Deducting my commission costs, perhaps I make a $2 profit that day. It doesn’t seem that much, but if I can repeat that 200 times during the year, I’ve used $200 to generate $400 in profits, or a 200% return on investment.

Of course, repeating that positive performance on a daily basis while investing thousands more dollars is what separates the professional from the soon-to-be-destitute amateur. And the pivot point strategy is one of the tools the professionals use.

Floor traders originally developed this strategy because it was an extremely simple way to predict when rising or falling prices would reverse direction.

The basis of the strategy is rooted in market psychology. Buyers tend to have a natural resistance to paying too high a price for a currency, and that’s called a resistance price. Conversely, if a currency price goes too low, buyers consider it a bargain and start buying it. That’s called a support price.

On most days, currency prices revolve around a center value and bounce back and forth between the support and resistance prices. So when the price drops to the support price, expect people to start buying. When it rises to the resistance price, expect them to start selling. (You can find a variety of formulas for calculating one or more support and resistance levels.)

The name “pivot point” relates to the center value around which prices pivot, and also the upper and lower psychological limits where prices pivot on themselves and reverse direction.

To use this strategy, buy when the currency hits the lower support value, and sell after it runs upward. When the currency hits a resistance value, sell, then buy after the price falls.

Of course, this is not a perfect algorithm. Sometimes when a price hits an upper or lower barrier, it keeps going. Usually once it passes that psychological boundary, it can continue to rise or fall until a second emotional barrier is reached. Some pivot point methods calculate these secondary, and even third-level boundaries.

Part of the reason for the success of this strategy is that everyone uses it. They have all calculated their support and resistance prices, and will buy or sell when those prices are reached.

In day trading, those who react the fastest capitalize on the change of direction before the herd follows into the market.

The most successful traders are tracking price fluctuations by the minute, but they have several other supporting indicators they rely on before making a decision. Thus, their secret to success in day trading is move fast but place only bets with higher odds of winning.

As funny as it sounds given day-trading is such a high-risk venture, the conservative day trader is the hare to the frantic trader’s rabbit.

by Steve Holder