Confluence in Forex Trading: Finding a Balance | Litefinance (2024)

In trading theory, confluence is the use of two or more different instruments that filter and confirm each other's signals. The most common combination is technical analysis indicators with trend lines, key levels, Fibonacci levels, and Price Action patterns.

A trading system in which the instruments complement each other provides fewer false signals, helps reduce risks, and manages trades more efficiently. But when the tools are out of sync, chaos ensues in the trading system. In this article, you will learn how confluence trading works, what combinations of tools exist, and how to apply them in practice.

What is confluence?

Confluence trading combines several indicators or strategies to achieve greater efficiency. If you use multiple indicators, indicators + levels, or indicators + Price Action patterns, you are applying the confluence method.

Confluence in the trading system:

• Confirms each other's signals. Each of the analysis tools has its own calculation formula and construction principle. Therefore, in different situations, they give different signals. If all instruments show a signal simultaneously (thereby confirming each other), you get a trading idea, for example, for opening or closing a trade, increasing volume, partially closing, or reversing a position. If there is a discrepancy between the indicator signals, it is better to stick to a wait-and-see approach.

• Improves signal accuracy. If the indicator has 40% of successful signals, the second has 50%, and the third has 60%, the confluence of several trading signals will increase their accuracy. Indicators serve as filters for each other. But the more instruments used, the less often confluence will appear.

The idea of the confluence of signals is to find the optimal combination of tools and strategies to show maximum efficiency with a minimum level of risk and time spent in one trading system.

What does confluence mean in trading?

In many sources, confluence is interpreted as using different technical analysis tools simultaneously. For example, a combination of indicators and levels of resistance, support, trend lines, and Price Action.

Below are possible combinations of instruments that can be used together in trading systems:

1. A combination of several technical analysis indicators:

• A combination of one indicator with different settings. An example of a common strategy is Forex trading using several moving averages with different periods. Periods are responsible for short, medium and long-term price averaging. When the signals of all moving averages match, a trade is opened. For example, the Alligator indicator is based on this idea. When all the moving averages of the Alligator intersect, there is no trend. The divergence of moving averages is a signal for the beginning of a trend.

• A combination of indicators with different types of action. A classic example is trend indicators & oscillators or channel indicators & oscillators strategies. The first indicators give the main signal, while the oscillators give a confirming one. Another option is a combination of trend indicators and ATR. It can be used to assess the level of current volatility and check for a trend.

• A combination of different indicators with the same type of action. For example, a combination of three oscillators shows overbought and oversold zones. Stochastic alone gives a lot of false signals. Other oscillators are not ideal either. But, due to the different calculation principles, they can be used together. If, for example, Stochastic, RSI, and CCI give signals on the same candle, you can open a trade.

2. Combinations of indicators and graphical analysis:

• Combination of indicators and levels. There are several types of levels, namely resistance and support, trend lines, round levels, and Fibonacci levels. They can form supply and demand zones (another instrument for finding a range with confluence signals). In most cases, these instruments are of a psychological nature. Levels can be combined. For example, trading trend lines and resistance and support levels is a variant of the confluence strategy. A breakout of a trend line at a key level serves as a signal for a trend reversal. In combination with indicators, the levels give confirmation signals.

• Combinations with Price Action. The formation of a reversal pattern near the key level serves as a signal for a trend reversal. If it is additionally confirmed by an indicator or an oscillator, you can open a trade.

3. Combination of indicators on different timeframes. One of the market analysis methods involves comparing the indicators' readings at the highest and lowest intervals. If H4 and H1 show a distinctive uptrend, then after looking for confirming signals on H1 you can open a long trade. Elder's triple screen strategy is based on a similar principle of using basic oscillators at different intervals.

4. Combinations with additional instruments. For example, using market sentiment or Pivot points as a trade idea or confirmation.

5. Combination of technical and fundamental analysis. The release of macroeconomic statistics and the publication of financial statements can set the start of a new trend. Trend confirmation by technical analysis serves as a signal to open a trade.

Although this is an incomplete list, it is enough to understand which variants of instruments can be combined in different strategies. It can be supplemented with volume indicators allocated to a separate group of Volume Spread Analysis, Spectrum Analysis tools (ATCF), and others.

How does a confluence happen in trading?

Each indicator has an interpretation and a logical explanation of its readings. For example:

• Stochastic or RSI are in the overbought zone. This may indicate that investors do not want to buy an asset that is too expensive, which means there will be a trend reversal, and a sell signal will appear.

• Resistance levels are psychological levels where buyers can set take profits and sellers can set stop losses.

• Channel indicators show the standard deviation of the price from its average value for the period specified in the settings.

All instruments have different formulas and interpretations. Therefore, each of them shows a signal at a certain time. When several trading signals coincide at the same time, this is called a confluence. It can occur both on one candle and in a zone. The zone is the time interval in which the preliminary and warning signals first appear and then the main and confirmation ones.

Confluence factors in technical analysis

Confluence factors are separate signals preceding the main signal. Below is an example of how to trade them in Forex.

A rather distinctive support level is formed on a downtrend from which the price rebounds and breaks out of the trend line with a candle with a large body. The first confluence factor is the breakout of candle 1, but the stochastic on it is in the overbought zone. The divergence of signals does not give a reason to open a trade.

After the trend line is broken out, the price tests the second support level. However, even here, the stochastic does not give a distinctive signal (2). The second confluence factor is the support level retest.

The price tests the support for the third time and breaks it out, but the breakout is false. On candle 3, all factors merge into a single signal:

• The downtrend line has been broken out, and the price failed to return to it twice.

• The second support level has been tested and broken out up.

• Stochastic is in the oversold zone, reversed, and goes up.

It is possible to open a long trade on candle 3 or the next after it.

How to choose technical analysis tools

The strategy's effectiveness depends on how accurately you can find a balance between the number of indicators, accuracy, and frequency of signals. For example, trend and channel indicators are rarely combined. It is also uncommon to use some oscillators with support and resistance levels and trend lines.

Rules for choosing technical analysis tools for the formation of a trading system:

• Combine different types of instruments. There are various options for using the three oscillators or different graphical analysis instruments. However, it is better to use different types of indicators, including a combination of trend indicators, oscillators, and graphical analysis, including Price Action.

• Prioritize between instruments. You must determine which instrument is the main and which is the auxiliary. This choice depends on the strategy. If you work with a trend, you get the main signal from a trend indicator and only then look for confirmation from other instruments. It is important to understand which signal is mandatory and which indicator signal can sometimes be neglected.

• A lot doesn't mean good. One indicator in a strategy is not enough, but this does not mean that by installing five indicators, you will immediately get an ideal trading system. Firstly, there are no ideal strategies, and there will still be false signals and losses. But it will take a long time to wait for the coincidence of all factors at the same time. As a result, you get rare signals and are unlikely to make a lot of profit. Secondly, many indicators visually overload the chart, increasing the risk of error.

You can choose a combination of instruments using the strategy tester. Take ready-made optimized trading systems from the Internet as a basis and select indicators with settings, experimenting with graphical analysis.

Combination of fundamental and technical analysis

Technical analysis is based on historical and mathematical patterns. On the other hand, fundamental analysis brings some chaos into the patterns. Unexpected news can reverse any sustainable trend, but fundamental analysis can also work for one's benefit.

How to combine technical and fundamental analysis:

• Use the economic calendar. It shows the release time of the main news and data. There is also a financial income calendar for the financial market.

• Study the forecast. If the actual data matches the forecast, the news will have little effect on the asset's price, and the trend will continue.

• Determine the trend direction according to the forecasts.

• Determine the trend direction by technical analysis.

• If the signals match, open a trade.

For example, you opened EUR/USD short trade according to technical indicators. The Fed once again raises the rate, which strengthens the US dollar. This means that the fundamental factor confirms the direction of the opened trade.

Fundamental trading is a high-risk system. Therefore, it is better to wait for the release of the news, look at the direction of the price, and only then receive confirmation from technical indicators.

How to find a confluence in the market?

The point of trade confluence in the market is the coincidence of the signals of several instruments. However, if there is a small time gap between the signals, should this be considered confluence? What gap is acceptable? Only testing the strategy on a demo account will help answer this question. Much depends on the specific trading strategy:

• In some strategies, the coincidence of the signals of all indicators on one candle is important. A divergence of even one candle can cause a late entry into the market. In scalping, where every minute counts, a late entry will result in a loss.

• Some strategies allow a divergence of two or three candles. Most often, this applies to long-term trend systems. In a strategy where the goal is to make a profit on 10 or more candles, it is allowed to form a signal on 2-3 candles.

• Some strategies allow the formation of preliminary and confirming signals, the gap between which is three or more candles. For example, a break of a key level and a trend line is a preliminary signal. Its test, followed by a rebound, serves as the main confirming signal.

The two most common groups of instruments used in confluence are a combination of technical analysis indicators and levels with Price Action.

Support and resistance

These are technical and graphical analysis instruments that determine the trade confluence zone, that is, the zone where entry and exit points can be found.

These include:

• Horizontal resistance and support levels are drawn by two or three extremes where the price most often reverses. Their breakout may mean a continuation of the trend movement.

• Trend lines indicate the trend direction and the borders of the rebound.

• Round levels are of a psychological nature. At such levels, people tend to close trades "just in case". For the same reason, there can be many stop-loss orders. Therefore, here the price can "delay", move into a flat, and change direction.

• Channels. Although this instrument belongs to indicators, channels are often used as flexible resistance and support levels.

• Fibonacci retracement levels are built according to the golden section principle. They form probable zones of the end of correction or the beginning of a new trend.

Levels indicate a confluence zone, while trend indicators show the point of opening a particular trade with the direction of movement or the point of closing a trade.

Example. One of the simple strategies often used in foreign exchange trading textbooks for beginners is moving average crossover trading with different settings. If the fast MA crosses the slow one upwards and the price is higher, a long trade is opened. If the fast MA crosses the slow MA from top to bottom, the price is below the intersection, and then a short trade is opened. In this interpretation, the strategy gives a lot of false signals.

The blue moving average is fast, and the red moving average is slow. Based on this, signals appear at points 1-6, indicated by blue arrows. All are false except the sixth.

Now, I add horizontal resistance and support levels. Their breakout will be the main signal, and the MA signals will serve as additional confirmations. Consider entering the Forex market only on the next candle after the breakout (red arrows):

• 1 - There is a breakout, but the moving averages are intertwined. Therefore, there is no signal.

• 2 - There is a breakout, but the fast-moving average has not reached the slow one. Therefore, there is no signal.

• 3 - There is a breakout. After crossing, the moving averages are directed downwards, but the signal is false.

• 4 - All conditions are met; a short position is opened on the second candle after the breakout. It closes at the moment the Absorption reversal candle appears.

Conclusion. Adding levels forming a trading confluence zone helped filter out false MA signals. Although one signal (red arrow 3‎) turned out to be false, the second signal (‎4) helped to earn about 30 points. This corresponds to 300 USD if the trade was opened with a volume of 1 lot.

Technical analysis indicators

The example described earlier shows how technical analysis indicators can be used as confirmation. They can also act as the main ones.

Below are the most successful combinations of indicators:

• Trend indicators and oscillators.

• Trend indicators, ATR, and volume indicators.

• Channel indicators and moving averages.

• Indicators showing the strength and direction of the trend and oscillators.

A combination of several oscillators filtering each other's signals is possible. It is undesirable to combine several trend indicators.

Five pips rule

The five pips rule implies that you don't always have to hurry. Signals from indicators do not always converge on one candle. Their combination on different candles forms the so-called trading confluence zone. For example, a reverse corrective movement, which has a visible zone, is formed on a trend movement.

Example. The price breaks out the trend indicator and the moving average from top to bottom. In theory, this is a sell signal. The five pips rule says if you see a confluence zone, place pending orders five pips above or below it. The rule is based on the fact that the trade confluence zone is the key zone in which the decision is most likely to be made by the majority of Forex traders.

In this case, it can be either a breakout of the support level, followed by a downward movement, or a rebound from support, a breakout of resistance, and the continuation of an uptrend. Set pending orders 5 pips below support, 5 pips above resistance and wait for one of them to trigger. In this case, the second option worked, that is, placing a trading pending order above resistance.

You can set stop losses using the same principle. Are you sure that a correction is now visible and that the trend will continue soon? Open a long trade, set a stop loss 5 pips below the support level.

Confluence trading examples

Graphical analysis tools are well combined with each other, including without indicators. Indicators are a mathematical algorithm based on historical data. They do not consider the market's psychology, the actions of market makers, and fundamental factors. Levels are the market's reaction to current factors. If you can read them, you can understand the psychology of the majority. Examples of confluence models in Price Action with levels are listed below.

Support level confluence trading

One of the most common working confluence chart patterns in graphical analysis is the combination of horizontal levels and a trend line.

Example. The long-term strategy is based on analyzing a relatively large time range to find the exact signal that allows you to profit on a price movement of at least 10 candles on the H1 interval. Time range of the strategy: April 26 - May 8.

The strategy algorithm. Input data for May 1 (vertical dotted line):

• A support level (S1) has been formed on the EUR/USD chart. It was built on the points with red arrows (1-3). At point 2 the shadow almost touches it.

• There is a downward trend line marked with blue arrows (1-3). Despite the fact that the price does not reach the line on the second arrow, the chart shows a downward movement with a large amplitude of volatility.

• There is a resistance level (R2) built on points 3 and 4 (blue lines). At point 2, the price broke out this level, but the downward movement indicates a further strong downtrend.

Wait for the end of the downward movement and find an entry point on the reversal upward movement. The combination of signals from the S1 support level and the trend line will serve as a trade confluence.

• After a small breakout of the S1 support level, the price goes up and breaks out the trend line. At point 1 (brown arrow), you can open a long trade, as there are two confluence signals, namely a rebound from support and a breakout of the trend line.

• There is a risk of the price bouncing down from the resistance level R2. Therefore, a more conservative option is to open a long trade after its breakout (brown arrow 2).

• The resistance level R1 (the level where a long trade is closed) is drawn at the maximum point.

• The price retests the resistance level (green arrow, point 2) and goes down. This is a good signal to open a short trade with the target at R2, which turns into a potential support level.

The price breaks out R2 and almost reaches the trend line (brown arrow 3). There is no obvious touch of the trend line, but there is a long shadow, so it is better not to open a trade.

The price rises just above R2, confirming that this is a strong resistance level. Then, it goes down and bounces up from the intersection of the S1 support level and the trend line. In this case, open a long trade and set a take profit at the R2 level.

Resistance level confluence trading

Here the idea is similar. A short trade is opened at the confluence of signals at the resistance level and the trend line. The USD/CAD H1 chart serves as an example. It often shows prolonged trends, so looking for reversal points here is easier than using high-volatility pair charts.

At the moment when the impulse uptrend will end, you can build an upward trend line at three extreme points. The chart also shows the resistance level, near which the price was before the impulse breakout. The end of the impulse may indicate that the uptrend will end soon, and you need to look for a point to open a short trade.

After a slight downward movement, a correction begins. At the moment of its end, the price rebounds simultaneously from the trend line and the resistance level. This increases the probability of profit in case of opening a short trade.

Trendline confluence trading

Trendline confluence trading is the same combination of a trend line with other elements of chart analysis, including resistance and support levels, Fibonacci retracements, and patterns.

This version of the trendline confluence strategy has an amplifying factor in the form of a retest after a breakout. For trending strategies, a retest serves as a strong signal confirming the reversal. In combination with a rebound from the resistance level, a triple confluence occurs, that is, three matching signals and confirmation from the reversal pattern (price action confluence trading).

NZD/USD CFD hourly chart above shows:

• After a short period of a flat market, an uptrend began. At 14:00 on March 14 (vertical dotted line) there are three points 1-3, which can be used to build a trend line.

• The price rebounds from the trend and goes up at point 3. But the trend becomes weaker with each candle, the amplitude and bodies of the candles also decrease. It is possible to build resistance at point 4 and the first high at the same level.

• The price returns to the trend line again, three candles go up along it. On the fourth candle, the price reaches resistance again, but cannot break it out.

• At point 5, the trend line was broken out downside, but the sellers are not strong enough to reverse the trend. There is no confluence here yet, as the breakout was not fixed, the candle closed at the trendline level.

• The first breakout is followed by a second one, a retest (candle 6), a rebound, the formation of a pin bar (a candle with a small body and a long shadow up) and an engulfing pattern (a candle with a large body down, engulfing the previous pin bar).

There are 4 confluence factors here: a rebound from resistance, a retest at the trend line, a subsequent rebound down, and the beginning of a reversal pattern. All this indicates the beginning of a downtrend. Wait for another candle to appear and open a short trade on candle 7.

Fibonacci level confluence trading

Let's take a closer look at this trading strategy. Fibonacci levels are based on a mathematical model, although it is believed that they take into account subconscious analysis of human psychology, so they provide a lot of false signals. But in combination with horizontal levels, they give relatively accurate signals. The instrument is used to find the moments when the correction ends. If one of the Fibonacci levels coincides with the support, then this indicates a confluence of signals.

AUD/USD H4 chart was used as an example.

The current moment is marked by a vertical dotted line (15:00, June 18). The chart shows a formed uptrend with frequent relatively deep corrections:

• A decline begins, which may turn out to be a new trend or correction.

• Using the points with red and blue arrows, it is possible to build levels that can serve both resistance and support at different times.

• The first Fibonacci level of 0.236 coincides with one of the levels. The price touches it, stops, but breaks out the level further.

• The second Fibonacci level of ‎0.382‎, coinciding with the second level, is stronger. The price bounced off it. As a result, it is possible to open a long trade on the brown arrow with a target Fibonacci level of 0.

The idea of this confluence strategy is that horizontal levels are confirmed by Fibonacci retracements. Although confluence does not provide 100% accurate signals, it increases the possibility of a correct decision.

Pros and cons of confluence trading

Pros of confluence trading:

• Improved signal accuracy. With the right selection, the indicators filter each other's signals. This reduces the number of false entries and unprofitable trades.

• Understanding the algorithm of actions. Unsure when to close a trade? The confluence of the indicator signals will tell you the relatively exact moment of the end of the trend.

• Risk diversification. There are no ideal indicators and tools. By applying different combinations for different assets and in different market situations, you test the effectiveness of each of them. Thus, you diversify risks and select the best option of confluence. The effectiveness of combinations is determined by the backtest parameters.

• Confidence in your actions. Focusing on the data of several indicators gives confidence. For example, you need to close a trade urgently, but all the indicators say the opposite. Use confluence strategies. Intuitive trading is good only when you have a lot of experience and a good amount of knowledge.

Cons of confluence trading:

• Not all instruments are compatible with each other. For example, the use of two different channel indicators can bring chaos to the trading system. This can make you doubt, and doubt in trading is the first step to a loss.

• Reducing the number of signals. Multiple trade signals appear less frequently since you need to wait for their coincidence from different instruments. This disadvantage can be leveled by using the trading system simultaneously on several charts of price pairs.

• Wishful thinking. For example, the main indicator shows an expected trend reversal. In this regard, you immediately start looking for a confirming pattern or drawing levels the way you would like to see them at the moment. In fact, there is no reversal pattern and levels, and the reversal signal itself turns out to be a mistake.

Below is a comparison table of the confluence strategy pros and cons:

The main success factor of confluence trading is the selection of the optimal number of instruments that complement each other. Their number can be two, three, five, that is, as many as necessary for balanced, harmonious work. There is no need to overlay five indicators on the chart at the same time, as they will interfere with each other visually. But you can use trend indicators, oscillators, levels, as well as take into account market sentiment and fundamental factors.

• If your trading strategy with one or two indicators gives 90%* or more successful trades, then additional confluence tools can only make things worse.

• If your trading strategy with five or more instruments gives 50% of successful trades, then their number should be reduced or the combination should be changed.

• If your trading strategy is based on three to five instruments and its profitability is 90% or more, then you have a perfectly balanced confluence strategy.

*The figures of 50%, 90% are taken as an example since each trader has different profitability goals and different conditions.

The strategy tester will help you choose instruments for a balanced trading system. Using historical data, it is almost impossible to take into account the influence of such fundamental factors as spread expansion, a sudden trend reversal, and the actions of market participants. But using the tester, you can choose the optimal combination of indicators and their settings with graphical analysis, which increases the possibility of successful trades.

Conclusion

• Confluence in trading is the use of several tools or a combination of several strategies to increase the probability of a successful trade.

• The most common confluence combinations include trend indicators and oscillators, the same indicators with different settings, trend lines with resistance and support levels, patterns and indicators, fundamental and technical analysis.

• Confluence helps you filter out false signals, get a preliminary and main signal for opening or closing a trade, increase the income from each open trade, and save time when the frequency of signals decreases.

• Confluence problems include an incorrectly selected combination of indicators, whose signals contradict each other, "overloading" of the trading system, a decrease in the strategy effectiveness due to incorrect data interpretation.

• The tester is software that allows you to choose the optimal combination of technical indicators and their settings with graphical models.

If you are a beginner trader, then start with the simplest combinations from the point of view of psychology, such as trend indicators with Price Action, supply and demand zones.

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.