The profitable power of confluence

October 1, 2014 07:00 AM

The field of technical analysis is so broad that no trader, beginner or otherwise, could possibly incorporate all of its aspects into his own trading. Furthermore, even with this ability, there would be no guarantee that it would improve profits; success is far from correlated with complexity. There is, however, one concept that governs the whole field. This concept is something that transcends any one indicator, system or candlestick pattern, and something that traders of any experience, style or approach can incorporate into their strategy to improve results. The concept is confluence.

Most readers are likely familiar with the term “confluence” in its geographical connotation. For those who are not, confluence traditionally relates to the coming together of one or more bodies of water—the point at which two rivers meet, for example. Its application to technical analysis has a similar definition, the only difference being that a charting technician’s body of water is a trading signal. 

To explain, it is first important to delve into what drives the theory behind technical analysis. Technical analysis is all about probability. The assumption chartists make every time they place a trade is that market conditions repeat themselves, and that things like moving average crossovers, double tops and overbought oscillators precede these repeating conditions. Trading in response to these aforementioned signals increases the probability of a winning trade.

When indicators fail

Pin bars are one of the most well-known, and most traded, candlesticks in technical analysis. A pin bar forms when an asset opens and closes a session at similar prices, but trades either up or down before doing so. The resulting candlestick has a small, thin body and a long tail or wick, the underlying assumption being that the bullish, or bearish, momentum that drove price back to its session open will carry over to at least the next session.

A pin bar can be a great way to identify entries with the trend after a correction, or countertrend trades at potential reversal points. A short scroll through the historic price action of any asset will reveal numerous pin bars that, if traded as described, would have been profitable signals. The problem is the same scroll will also reveal many pin bars that meet the criteria, yet would have resulted in a losing trade. 

This is where confluence comes in. Confluence improves the probability of a pin bar’s profitability, and in turn, the efficacy of a pin bar-based strategy. To incorporate confluence into a strategy, simply look for other signals or indications that support the initial pin bar’s directional bias. To illustrate, take a look at “Better trades” (below).

The first chart shows a bearish pin bar forming after about a week following Australian dollar strength. Many traders would spot this pin bar and enter a short trade based on the aforementioned bearish bias assumption. This would be a perfectly valid trade and, combined with a sound target, would have resulted in a nice profit. 

The second chart also shows a perfectly valid pin bar, this time offering up a bullish bias. Again, many traders would have entered long based on the bullish bias this pin bar offers up. This trade, however, would not have worked out. Upon its close, the bullish pin bar preceded a substantial decline in the strength of the dollar vs. its Swiss counterpart.

Filtering opportunity

The question is, “How can a trader differentiate between a good and bad signal if it meets its own criteria?” The answer is confluence.

The first chart in “Trading with confluence” (below) takes a longer-term perspective on the bearish pin bar highlighted in the first chart in “Better trades.” The first thing to note is that the bearish pin bar formed at a historically relevant level. In this instance, the level was a resistance point (around 1.0610), at which the AUD/USD reversed to the downside a little over one month earlier. This resistance level initiates confluence and strengthens the bearish pin bar.

The second point of note is the position of the pin bar in relation to the Bollinger bands. The wick of the pin bar breaks through the upper, outer Bollinger band, which on its own suggests a reversion to the band’s central moving average might be due. Furthermore, having broken through the band, the AUD/USD failed to close above it. In other words, selling pressure above the two standard deviations from the 20-day moving average outweighed buying pressure. In short, a downside entry in line with the bearish pin bar would be a three-signal trade, supported by the bearish bias of both a key resistance level and a pending mean reversion. 

Now take a look at the second chart in “Trading with confluence.” Again, this chart shows a longer-term perspective of the bullish pin bar highlighted earlier. The first point of note on this chart is that the bullish pin bar formed in the middle to upper end of a range. In other words, the pin bar offered up a bullish bias, while support and resistance analysis would have favored a bearish bias. This conflict weakens the pin bar straight away.

It’s also important to understand that the pin bar formed around its 20-day moving average. Neither the U.S. dollar nor the Swiss Franc were significantly overbought or oversold at the level at which the pin bar formed. In short, a bullish entry based on the pin bar would be a bullish entry based solely on the one signal. 

While these are relatively crude examples, and confluence will not always guarantee profitable trades, the key takeaway is that a signal is strengthened when another signal, or more, support its bias. It does not matter what signals a trader uses. The pattern and indicator used in these examples were chosen for simplicity’s sake, but they could be replaced with an oscillator, another pattern or whatever strategy a particular trader employs. 

There is a limit to the power of confluence, of course. As mentioned, it would be impossible for a trader to take stock of all the various signals offered up by every indicator. It is likely that many would conflict with one another anyway. This, however, is not important. A trader who bases his or her entries on 15 confluent signals will likely have no more success than one who bases his entries on two or three, but both of these traders will almost definitely be more successful than the trader who bases his entries on just one. 

All said, confluence is one of the most powerful tools a trader can incorporate into a trading arsenal. A trader who seeks the confluence of a number of signals can trade under the confidence that while it might reduce the number of entries a strategy dictates, it will vastly improve the reliability of those entries and, in turn, the overall profitability of a strategy.

Samuel J. Rae is the author of
Diary of a Currency Trader: A Simple Strategy for Foreign Exchange Trading and How it is Used in Practice, published in December 2013 by Harriman House.

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