Daily Pivot Breakouts

TRADING STRATEGIES

Daily pivot breakouts When attempting to trade mechanically defined intraday support and resistance levels, don’t forget the time element. BY DANIEL FERNANDEZ

)HZWHFKQLFDODQDO\VLVWRROVDUHDVZLGHO\XVHGDVsupport and resistance. However, the difficulty of systematically defining support and resistance levels has resulted in a scarcity of fully mechanical systems based on them. This article outlines a trading strategy based on pivot points — mechanically defined intraday support and resistance levels — and shows its long-term statistical performance in simulation. These results indicate developing a successful system from pivot-point-based inefficiencies in the forex market is possible.

Pivot-point calculations 3LYRWSRLQWVDUHIRUPXODVRIWHQDWWULEXWHGWRDWUDGLWLRQ passed down among floor traders) used to determine support and resistance levels derived from the high, low, and FORVLQJSULFHV+/& RIWKHSUHYLRXVSULFHEDU$VWKH

years progressed, these levels became ingrained in the WUDGLQJFRPPXQLW\·VFROOHFWLYHFRQVFLRXVQHVVDQGHYROYHG as standard support and resistance levels used by a wide range of traders. 3LYRWSRLQWVDUHGHILQHGLQDPDWKHPDWLFDOO\SUHFLVHZD\ using the information from the previous trading day (new levels are generated every day). The pivot-point value is DGGHGWRDQGVXEWUDFWHGIURPWKHSUHYLRXVEDUV·UHIHUHQFH points to determine several support and resistance levels. 7KHSLYRWSRLQW33 IRUPXODLV 33

The support and resistance levels derived from the pivot point are:

FIGURE 1: SAMPLE TRADE

A long trade was triggered when a 60-minute bar opened above the R2 resistance level. Source for all figures: MetaTrader 4

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+ / $W\SLFDOFRXQWHUWUHQGSLYRWSRLQW application is to cover any short positions and go long at either of the two support levels, or sell any long positions and go short at the projected UHVLVWDQFHOHYHOV$OWHUQDWHO\EUHDNRXW trades could be placed if price pushes above the resistances levels or below the support levels. When building a pivot-point-

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based trading system it is important to define which approach will be used — that is, whether the levels will be traded in countertrend fashion in expectation of range-bound price action (between the various support and resistance levels), or if the levels will form the basis of a breakout strategy, in which moves above resistance imply further price gains and moves below support imply further declines. This analysis explores DV\VWHPEDVHGRQEUHDNRXWVRIWKH65OHYHOVLQWKH (XUR86GROODUSDLU(8586' 

A pivot breakout strategy The system uses a very simple entry logic: The sysWHPJRHVVKRUWZKHQDQKRXUO\PLQXWH EDURSHQV EHORZWKH6VXSSRUWOHYHODQGJRHVORQJZKHQDQ KRXUO\EDURSHQVDERYHWKH5UHVLVWDQFHOHYHO *RORQJLIRSHQ!5 *RVKRUWLIRSHQ6

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Trades are exited by either a stop-loss, a profit target, RUDWLPHEDVHGH[LW7KHVWRSORVVLVSODFHGDWWKH6 OHYHOIRUVKRUWVDQG5OHYHOIRUORQJVZKLOHWKHSURILW target is placed at a distance equal to the difference EHWZHHQWKH33DQGWKH6OHYHOIRUVKRUWV RUWKHGLVWDQFHEHWZHHQWKH33DQGWKH5OHYHOIRUORQJV 7KH WLPHEDVHGUXOHVLPSO\FORVHVDQ\RSHQWUDGHKRXUV after entry. This criterion reflects the idea that the inefficiency the system is attempting to exploit is based on intraday support and resistance levels, which should lose their relevance as time passes. 7UDGHVL]HLVGHWHUPLQHGE\WKHIROORZLQJHTXDWLRQ which is designed to result in per-trade risk of approxiPDWHO\SHUFHQW

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7UDGHVL]H  DFFRXQWEDODQFHLQ86'FRQWUDFW size in USD*|[trigger level – pivot level|) where, Trigger level = R2 for long trades or S2 for short trades )LJXUHVKRZVDVDPSOHWUDGHIURP6HSW The pivot levels for that day (based on prices from 6HSW ZHUH 3LYRW  6  6  6  5  5  5 

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The above information has been approved and/or communicated by Deutsche Bank AG London in accordance with appropriate local legislation and regulation. Deutsche Bank AG London is regulated for the conduct of investment business in the UK by the Financial Services Authority. Trading in margin foreign exchange can be risky. The use of leverage in foreign exchange trading can lead to large losses as well as large gains. Markets referred to in this publication can be highly volatile. For general information regarding the nature and risks of the proposed transaction and types of financial instruments please go to www.globalmarkets.db.com/riskdisclosures. This product may not be appropriate for all investors. Before entering into this product you should take steps to ensure that you understand and have made an independent assessment of the appropriateness of the product.

TRADING STRATEGIES

:KHQWKHWKLUGKRXUO\EDURIWKHGD\RSHQHGDW DERYH5 DORQJWUDGHZDVWULJJHUHG$VWRSORVVZDV SODFHGSLSV² EHORZWKHHQWU\SULFH DQGDSURILWWDUJHWZDVVHWSLSV² DERYH WKHHQWU\SULFH$VVXPLQJDDFFRXQWEDODQFHDQG DVWDQGDUGIRUH[FRQWUDFWVL]HWKHWUDGHVL]HZDV   __ ,QWKLV case the trade was closed at the profit target. 1RWHWKDWWKHDPRXQWRIPRQH\ULVNHGSHUWUDGHFKDQJHV depending on how much the last hourly bar advances relaWLYHWRWKHVWRSOHYHO5RU6 ,QWKLVFDVHWKHODUJHEXOO-

ish bar immediately before the entry bar pierced both the 5DQG5OHYHOV$VDUHVXOWWKHV\VWHPDVVXPHGPRUHULVN (since the stop-loss would be farther away from the entry price), although the higher momentum increased the probability the market would reach the profit target.

System results 7KHV\VWHPZDVWHVWHGLQ0HWDWUDGHU RQKRXUO\(85 86'GDWDIURP-DQWKURXJK2FW7UDGLQJ FRVWVZHUHVHWDWWZRSLSV  )LJXUHVKRZVWKHV\VWHPZDVSURILWDEOHRYHUWKH FRXUVHRIWKHQHDUO\\HDUWHVWUXQERWKZLWKDQGZLWKout the time-based exit rule, although the former results TABLE 1: IMPACT OF THE TIME-BASED EXIT ZHUHPXFKEHWWHUWKDQWKHODWWHU7DEOHHPSKDVL]HVWKH Time exit w/o time exit underperformance of the version without the time-based exit. Trades that are likely to hit the profit target usually do Total profit 122% 54% VRLQWKHILUVWGD\PXFKIXUWKHURXWWKDQWKDWWKHUHOHYDQFH Win percentage 43.74% 32.83% of the intraday support or resistance breakout disappears, Maximum drawdown 17.28%  and positions run an increased risk of losses. By closing Avg. annual profit  5.15% WUDGHVDIWHUKRXUVWKHIXOOH[SHFWHGHIIHFWRIWKHLQWUDGD\EUHDNRXWLVUHDOL]HGDQGWKHHIILFLHQF\RIWKHV\VWHPLV Number of trades 727 664 greatly increased. Results are barely profitable without the Profit-to-loss ratio 1.53 2.18 WLPHEDVHGH[LWPDNLQJLWVLQFOXVLRQYLWDOIRUWKHVWUDWHJ\·V Profit factor  1.07 success. The time-based exit version of the system had only The time-based exit rule was a major component of the WKUHHORVLQJ\HDUVGXULQJWKH\HDUWHVWSHULRGDQDYHUsystem’s profitability. DJHFRPSRXQGHG\HDUO\SURILWRI percent, and a maximum drawdown of FIGURE 2: EQUITY CURVES SHUFHQW7KHVWUDWHJ\DOVRKDGD good average risk-to-reward ratio, with DQDYHUDJHSURILWDEOHWUDGHDWOHDVW WLPHVWKHVL]HRIWKHDYHUDJHORVV The annual returns provide important LQVLJKWDERXWWKHV\VWHP·VORQJWHUP trading characteristics, revealing it generated most of its profits during about RQHWKLUGRIWKHWHVWSHULRG·V\HDUVWKH others were either down years or essenWLDOO\EUHDNHYHQ)LJXUH &XULRXVO\ although the system trades on an intraday basis, some of its key performance characteristics — profits, drawdown length, and yearly return distributions — are similar to those of a long-term trend-following strategy. However, Without the time-based exit, the system ended the test profitably, but overall because it seems to work best in condiperformance was flat. With the time-based exit, equity more than doubled. tions that appear mostly range-bound

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Related reading By Daniel Fernandez:

RQWKHGDLO\WLPHIUDPHHJ  WKHV\VWHPFRXOGSRWHQWLDOO\ function as a useful complement to a daily time frame trend-following system, such as the moving-average system described in “Multiple averDJHWUHQGIROORZLQJµCurrency Trader, 1RYHPEHU 

Time is key The analysis highlights two important aspects regarding mechanical pivotEDVHGVWUDWHJLHV)LUVWLWLVSRVVLEOH to develop systems that successfully trade intraday mathematically defined support and resistance levels. Second, the time-exit criterion is critical for the success of this strategy. If you want to develop strategies using pivot levels, it is important to consider the appropriate holding period, and implement a rigid time cutoff to exit positions if they fail to reach the intended profit or loss targets. This reduces the number of positions left to chance and increases the likelihood that profits accumulated from these short-lived inefficiencies are effectively captured. This strategy offers only a glimpse of the possibilities of this type of VXSSRUWDQGUHVLVWDQFHDQDO\VLV)RU example, the system did not make use of a longer-term time-frame filter or any additional mechanism to improve entry accuracy. Other inputs, such as the inclusion of additional volatility criteria (e.g., allowing or disallowing trades when volatility reaches a certain level) might further refine the entry and exit mechanisms DQGDFKLHYHEHWWHUUHVXOWV)LQDOO\ WKHVWUDWHJ\FRXOGEHRSWLPL]HGDQG tested on other currency pairs and be applied to a basket of instruments. ` For information on the author, see p. 4.

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Multiple average trend-following Currency Trader, November 2010 Translating a multi-moving average technique into a mechanical forex-trading system highlights the benefits of simplicity and diversification. Validating candlestick patterns with tick volume Currency Trader, October 2010 A “double-doji” breakout strategy gets a boost from a tick-volume filter. Taking advantage of the Asian trading session Currency Trader, June 2010 Breaking down the range characteristics of the Asian forex session produces some surprisingly reliable trading statistics. Other articles: Putting pivot points to the test Active Trader, November 2006 Many view pivot points as potential intraday support and resistance areas, but does the market really respond to these levels the way traders expect? This in-depth analysis studies pivot points in stock-index ETFs. Fibonacci pivot points Futures & Options Trader, February 2008 This article compares two types of intraday pivot-point strategies. The first strategy uses standard pivot points, while the second strategy uses pivot points based on Fibonacci levels with the goal of defining more accurate support and resistance levels and boosting the technique’s reward-to-risk ratio.

FIGURE 3: ANNUAL RETURNS

The system posted eight profitable years out of 11 in the test period, and the average winning year was much larger than the average losing year.