Crypto trading needs a synergy of various tools and indicators — discover how a combination of different tools can help you make better trading decisions!
Previously, we’ve discussed multiple trading tools and indicators – and we often remind you how important it is to never trade using one tool in isolation. To discuss its importance further, let's dive into the concept of confluence.
Let’s take Patrick, who is just starting out his crypto trading journey, browsing the internet for ways to make money. On his search, he runs into trading educators, teaching him how to use their favorite trading indicators and tools – often presenting them as the golden ticket to trading success. When Patrick puts these tools to the test, he has a rather rude awakening. The indicators did not produce the results he saw in those YouTube videos, and he decides to look for more tools. This process repeats itself a couple more times until he gives up.
There are many stories like this one, of traders who experiment with a few different stand-alone tools, failing to turn a profit. In many cases, their problems could have been solved if they had looked for confluence between the different tools they were taught instead of moving from one to another.
Reliable trade signals are based on a group of tools pointing in the same direction, combining into a high-probability setup.
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What Does “Confluence” Mean in Trading?
The name confluence stems from geography – where it is used to refer to the point where multiple rivers merge into one. In crypto trading, we speak of confluence when multiple strategies or forms of analysis combine into a trading strategy. Alternatively, when two or more indicators line up on a chart – you can call it a confluence between those indicators. In any case, it occurs when two or more separate ideas, indicators or strategies are used in combination, forming a trade idea.
With confluence, traders can act with confidence. When multiple analysis methods tell you the same thing, there is a higher chance that your idea will play out. For example, when the RSI prints a bullish divergence on a stock that has very healthy finances, you can be confident that a bounce is coming.
Moreover, confluence helps traders reduce fake signals. We know that indicators can print fake signals, but when you combine the indicator with other forms of analysis, you will be able to tell those false signals apart from the good ones. After all – they will likely not have the same confluence that a good signal has. In essence, looking for confluence helps you reduce fake signals to the minimum.
Technical Analysis and Fundamental Analysis
Traders and investors rely on two primary tools to forecast market direction: technical and fundamental analysis. Technical analysis is the study of price action history to estimate the future direction, whereas fundamental analysis is focused on understanding the driving forces behind the market and using this understanding to forecast an asset’s performance.
Most shorter-term traders tend to prefer technical analysis, whereas long-term investors usually opt for a more fundamental approach. Nevertheless, high confidence can be based on a combination of the two. For example, when an investor wishes to buy a stock based on fundamental analysis, he can find optimal entry points based on technical levels. This confluence allows the investor to further optimize his trade, maximizing his reward relative to the risk.
Confluence Trading: Technical Analysis
Many traders make their trading decisions based on a foundation of price action and use trading indicators to add further confidence to their trading strategy. With so many different price action concepts and trading indicators to choose from, this confluence can take different shapes. Let’s look at how confluence works on a chart.
Trading Confluence Using Price Action
First things first, the foundation of a stock, crypto or forex trading strategy often lies in price action concepts such as support and resistance, chart patterns, market structure, trendlines, candlesticks and Fibonacci.
Let’s have a look at the chart below – showing recent Bitcoin price action. The chart shows a trendline, a support and resistance level, a Fibonacci retracement level and two areas where strong confluence exists.
Support Level Confluence Trading
One of the most common types of confluence in technical analysis is the one with support levels. After identifying a support level, traders can seek confluence with other forms of analysis. Such is the case in the example, where the support level lines up with a liquidity pocket from earlier. When the price reached that confluence zone, a significant bounce followed.
Resistance Level Confluence Trading
Resistance levels are often used in confluence with other tools as well. In this example, the resistance area lines up with the trendline (a sell signal) – leading to the sell-off into the support and liquidity area.
Fibonacci Level Confluence Trading
After the bounce from the liquidity pocket, the resistance level got an additional level of confluence. When drawing the Fibonacci retracements from high to low, the golden pocket (0.618) lines up perfectly with the S/R area. This additional confluence gave traders even more confidence to sell – resulting in two more rejections from the resistance level.
Trendline Confluence Trading
Finally, as we have seen in the above example, trendlines are an important component of confluence. Whichever analysis method you are using – having a trendline that adds to your idea never hurts.
Trading Confluence Using Technical Indicators
Another way of seeking confluence is by combining multiple technical indicators, such as a moving average, an oscillator and Bollinger bands. In the example below, we see Bitcoin price action combined with Bollinger Bands and the RSI. The area marked in red shows confluence because both the RSI and Bollinger Bands indicate that the price is overbought.
The bearish divergence adds even more confluence to the idea. All things considered, this indicates a potential reversal, and perhaps the start of a downtrend.
Trading Confluence Using a Combination of Technical Indicators and Price Action
When we combine indicators and price action, a better confluence is formed. The chart below shows the same price movement we studied earlier, but now with Bollinger bands and RSI as well. As you can see, these indicators add even more confluence to the levels we already marked. With the confluence of these different forms of analysis, traders can trade with confidence and prevent fake signals.
How Much Trading Confluence Is Enough?
One might wonder then; how much confluence is enough? To build a solid trading or investing strategy, traders should test their strategies. Practice with different methods and see which combinations give you the most reliable results.
Using more indicators is not necessarily better – as it can get overwhelming quickly. When too many indicators are used, analysis paralysis can become a problem. In our experience, successful traders combine price action analysis with one or two indicators and work with that.
Closing Thoughts
All things considered, trading is a very tough skill to master. Confluence can make the difference between a profitable strategy and a strategy that loses money.
All in all, confluence is a crucial trading concept to understand and master. With it, traders can take higher probability trades and reduce the likelihood of fake signals. It works on any time frame, whether you are day trading or swing trading.
In any case, even with solid confluence, trading remains a game of probabilities, not certainties. Always keep this at the back of your mind and exercise proper risk management to protect yourself against large losses.
Writer’s Disclaimer: This article is based on my limited knowledge and experience. It has been written for educational purposes. It should not be construed as advice in any shape or form. Please do your own research.
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