Confluence in trading means to integrate multiple strategies, tools and forecasting methods, into one complete trading system.
Every indicator and tool serves a unique purpose. For example, a moving average is useful to identify the direction and the trend of price over a period of time… and only that!
We know that any MA crossover strategy fails in most market conditions. The reason however, is not because the MA is lagging or the period settings are wrong. It fails because the MA is never supposed to be used as a trade-setup or an entry signal, period.
First step towards creating a successful confluence trading system, is to understand the purpose and the application of each tool or indicator, that would be embedded into the final complete system.
Segments of a confluence trading system
Engineers take a big problem and break it into a bunch of small problems. They will solve the big problem by solving one micro problem at a time.
The same concept and approach should be present in a confluence trading system.
Ideally the final system should include a practical method to determine the following:
- Directional bias in higher timeframes (macro view) and the current timeframe (standard view)
- Market depth and potential of the current timeframe
- Optimal timing to enter and exit trades
- Conditions to disregard a trade
- Order management and stop-loss and take-profit levels (exit strategy)
1. Top down analysis
Top down analysis means to start the chart analysis from higher timeframes such as MN, W1 and work towards the current. This allows for a comprehensive and more complete market analysis.
I personally use Elliott wave analysis starting from the MN or W1. Simply because Elliott waves can, not only determine the current status of the market, but also provide some insight into what could come next. Concept of wave-degrees also help creating more confluences between timeframes.
Analyzing the market is an important part of the confluence trading process. So chose your tools and methods carefully.
There are few important characteristics for the tools used for top down analysis in financial markets:
1. Does not emphasize on specific price points but direction or zones of the chart
Typically, the tool does not provide entry or exit price points and ideally works on both axis’ of the chart. This is why horizontal price levels (Y axis) or periodic dividers (X axis), are not suitable on their own.
Patterns on the other hand work on both price and momentum, which is a perfect fit for top down analysis.
The tool doesn’t have to be complex. It can be as simple as the MA or the MACD indicator. The directional confluence in trading is when directional bias is unified across timeframes.
2. Provide clues of confluence zones between the timeframes
“Confluences between timeframes” means changes in higher timeframes should explain the changes in the lower timeframes or vice versa. For example in the above chart, the bearish trend is due to the C wave of the ABC pattern in the monthly chart.
Let’s take a simple MA example. If the MA slope is diminishing in W1, the D1 must be, moving in the opposite direction or stuck in a sideways market condition.
Patterns, for example Elliott waves and Fibonacci ratios, can also help define confluence zones across multiple degrees.
2. Market depth and context parameters – another confluence factor
A very important data for day trading is the ATR – Average True Range. For example D1 ATR can provide clues regarding the potential of trades placed in H1.
According to the ATR on the EURUSD chart above, the current average (30 days) range is around 130 pips. Also notice the ATR is on the rise while the bearish momentum of C wave is increasing.
The tool should provide approximate calculations regarding the: how far and how long of a trade.
The context relates to defining stop-loss and take-profit levels or zones as well. Most traders focus on confluences for trade placements but unfortunately not for exiting the trade.
Exit strategy is discussed as a sub-topic of its own, further down.
Tool or a method to calculate depth and potential is crucial for a successful confluence trading system.
3. Timing is important for confluence
Major price movements for the day happens during trading hours pertaining to the countries or regions of the instrument.
E.g. Usually major moves of EURUSD happens between European and US trading hours. EURUSD is an extreme example though. But you get the idea.
For day trading strategies this could be the hour/s of the day to place or exit trades. Rules defining the duration of a trade too can help to weed out losing trades.
This is why timing is an important segment of confluences in a trading system.
4. Mechanism to reduce losing trades – exclusion by confluence
One way to improve a trading system is to anticipate and avoid losing trades as much as possible.
The good news is that a confluence trading system has so many data points that can provide helpful clues to define an exclusion mechanism.
Suppose one or more specific confluences are more frequent in losing trades, then those confluences can be used as the strategy to exclude trades.
5. Order management and exit strategies
Set and forget orders are the most preferred by traders of all grades. However, if the order-exit-strategy is limited to setting up stop-loss and take-profit levels, then there is little to no chance of long term profitability in such a system.
There are different schools of thought in this regard. But, in terms of transactions, exiting a buy order is identical as placing a sell order. Thus making the exit-strategy as important as the entry-strategy.
This is why confluences should be considered in order-management and order-exit as well.
The above chart has so many ways to look for possible exit zones. Think of it as looking for confluence zones to enter long.
Confluence in trading is a simple yet effective approach to mitigate risks and increase the profit potentials of your trades.