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.