article by CryptoJelleNL
We can cover endless trading-related topics, indicators, and analysis techniques, but the real magic happens when these different topics are merged into a synergistic trading system. In today's article, we dive into the concept of confluence, what it means, and how it can take your trading to the next level.
Different trading tools provide different directional clues. Putting these pieces of the hypothetical puzzle together can help form a clearer picture of where the market is headed.
So what is confluence?
Beginner traders often try out a plethora of different techniques, struggle to make them work, and then move on to the next tool or indicator. This process generally repeats itself a couple of times, before they give up.
In most cases, these beginner traders would have eventually figured things out, had they looked at using different tools in combination, rather than on a stand-alone basis. When multiple analysis techniques and indicators point in the same direction, you can act with more confidence.
This is exactly what trading confluence is, a combination of multiple strategies, used as one. The term originates from geography terminology, where it is used to describe the point where multiple flowing bodies of water (i.e., rivers) merge into one.
In trading, the term confluence represents either (1) a combination of multiple strategies, or (2) when two or more strategies or indicators line up on a chart.
Why does confluence matter?
Confluence helps traders to act with confidence. A combination of multiple analysis methods painting a similar picture, adds more weight to the idea. Essentially, more confluence is more confidence. For example, if Bitcoin prints a weekly bullish divergence in the weeks leading up to its halving date, I will be incredibly confident in prices moving higher over the weeks (and months) to follow.
Secondly, confluence is a great tool to reduce signal noise. Indicators are notorious for their fake signals, but when two or three indicators all tell you that the market is getting overheated, they are more likely to be right than wrong. A fake signal usually happens in conflict with the other tools, allowing you to spot them from the colloquial mile away.
Essentially, a confluence is a tool to trade with more confidence and less noise.
Confluence in Technical Analysis
Most traders build their trading systems on the analysis of price action, and add a few different tools into the mix, such as moving averages and the relative strength index, or cumulative volume delta and open interest tools. The possibilities are endless, but let's look at how confluence looks in practice.
The chart above shows recent Bitcoin price action, with two different examples where multiple tools of analysis point in the same direction. For example, in the areas marked in blue, Bitcoin was at support, RSI was oversold, and the MACD printed a bullish cross.
The green areas highlight a bearish MACD cross, while Bitcoin rejects from the MA cluster, and then loses the support level. In either of these scenarios, multiple tools point in the same direction, and traders can trade with more confidence.
Combining TA and FA
Most traders rely on either technical on fundamental analysis to support their trades. Generally speaking, technical analysis is the method of choice for short-term traders, whereas long-term investors prefer to use a more fundamental approach.
Nevertheless, when technical and fundamental factors line up, a high-confidence idea can be formed. For example, when an investor knows he wants to buy a stock based on its balance sheet, he can find the optimal entry based on technical analysis. This is a level of confluence that aids in finding the optimal entry, further boosting his odds of success.
Analysis Paralysis - How much confluence is enough?
After reading the above, you might feel like adding 20 different indicators to your charting software, and trading only when they all point in the same direction. However, even when it comes to confluence, less is usually more. Using too many indicators can get overwhelming, and the so-called analysis paralysis problem can come into play - where the sheer amount of indicators results in a lack of actionable insights because there will always be a tool that goes against the others).
Most seasoned traders use a combination of two, three, or four techniques, and build their entire trading system around it. This takes months if not years to perfect, through extensive testing. Practice with different methods, and see which combinations give you the best results.
All in all, understanding confluence is a key step in a beginner's trading journey. Confluence can make the difference between a losing strategy, and a trader that turns a profit. With confluence, traders act with confidence and avoid signal noise.
Nevertheless, even with confluence, a trading system is not entirely foolproof, so exercising solid risk management is a must.
Author's Disclaimer: This article is based on my limited knowledge and experience. It has been written for informational purposes only. It should not be construed as investment advice in any shape or form.
Editor's note: CryptoJelleNL provides insights into the cryptocurrency industry. He has been actively participating in financial markets for over 5 years, primarily focusing on long-term investments in both the stock market and crypto. While he watches the returns of those investments roll in, he writes articles for multiple platforms. From now on, he will be contributing his insights for Alpha Circle as well.
Check out his twitter: twitter.com/cryptojellenl
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