How to Combine Different Technical Analysis Methods to Create Stronger Trade Ideas

How to Combine Different Technical Analysis Methods to Create Stronger Trade Ideas

Introduction

Technical analysis is at the heart of the approach of most traders to the markets.

It seems to be more common for new traders to begin learning about technical rather than fundamentals.

This is perhaps because it is easier to understand visual trade ideas over ones based off underlying economic principles.

Regardless, learning to trade technicals is an effective way to approach the markets. Indeed, there are many experienced traders and successful funds that run purely technical strategies.

Issues with Trading Technicals

When starting out, many new traders will learn about the various technical elements such as trend lines, support and resistance, candle formations, and technical indicators.

Having seen a few examples of successful trades based on these different elements in isolation, they then begin trading with them.

However, most new traders typically run into issues with this approach for a number of reasons.

One is that they very often misunderstand the nature of the technical analysis they are using. The second is that they tend to use these elements on a stand-alone basis, without combining them.

So, over the course of this article we are going to discuss the proper application of these different technical elements and look at how to combine them to create stronger trading ideas based on technical confluence.

Technical confluence is the presence of two or more technical elements and is what all successful technical traders will tell you is a vital part of success when trading.

Support and Resistance

Support and resistance refer to horizontal levels in the market which are created through the underlying supply and demand in the market.

Visually they are found in areas where we can identify previous highs or lows.

A level where price has established swing lows is called support and it shows that there has been demand in the market at that level.

Typically, traders will look to buy price as it hits that level expecting that the demand will still be there, and the market will move higher.

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Resistance is highlighted by identifying swing highs, suggesting an area where price has found supply (selling interest).

Typically, traders will sell the market as it tests resistance, anticipating that the supply will send price lower again.

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Trend lines are similar to support and resistance in that they identify supply and demand areas but instead of horizontally, they do so along a diagonal gradient.

A bullish trend line is established by connecting rising lows. The trend line then acts as a support creating buying opportunities as price retests it.

 

A bearish trend is a downward sloping line that connects lower highs and identifies areas of resistance where traders can look to sell the market.

 

Fibonacci Retracements

The Fibonacci retracement tool is an analysis tool used to highlight support/resistance areas based on the underlying mathematical principles of the Fibonacci number sequence.

The tool is used to measure a rise or decline in price and highlights points within that move that will act as support/resistance if price corrects and tests them.

For bearish Fibonacci retracements, you measured= a decline in price from top to bottom and the tool will highlight several key areas such as the 38.2%, 50%, 61.8% and 78.6% retracement levels which can act as resistance if price retests them.

 

For a bullish Fibonacci retracement, we use the Fibonacci tool to measure a rally in price. The tool then highlights key retracement levels within the rally which can act as resistance if retested.

 

Candle stick Patterns

Candlestick pattern reading is a very in-depth area of technical analysis and certainly one well worth spending time exploring.

The basic premise of candlestick reading is that the shape of certain candles or combinations of candles tells us something about the underlying order flow in the market which can highlight trading opportunities.

The candlestick we are going to focus on in this article is the pin bar candle.

Pin Bar Candles

Pin bars are candles with a small body and a long wick. These candles get their name from the “Pinocchio” story where a child’s nose grew longer as he lied. They suggest that a market reversal is imminent.

A bearish bin par shows that buyers were initially in control, driving price higher before running into selling pressure that sent price all the way back down to the bottom of the candle leaving a long tail, or nose.

This suggests there has been a shift in sentiment and a bearish reversal is coming.

 

A bullish bin par shows that sellers were initially in control, driving lower before running into buying pressure which sent price all the way back up to the top of the candle leaving a long tail, or nose.

This suggests there has been a shift in sentiment and a bullish reversal is coming.

 

Technical Indicators

Technical indicators are again, another very deep field of technical analysis.

All charting software comes with a wide range of inbuilt indicators which measure things such as volume, volatility, momentum, trend direction and so on.

There are many fantastic indicators out there which we could explore. However, for the purposes of this article, we are going to focus on the RSI indicator.

The RSI Indicator

The Relative Strength Index is an indicator which measures momentum in the market; the strength of buying and selling.

The indicator itself is presented as a line chart which oscillates between an upper and lower limit. The upper limit reflects when price is considered to be overbought, e.g. when bullish momentum is stretched, and price is vulnerable to reversing lower.

The lower limit reflects when bearish momentum is over-stretched, and price is vulnerable to a reversal higher.

 

When it comes to trading the RSI index, there are many strategies favoured by traders.

However, one of the most effective methods, especially when it comes to combining the indicator readings with other readings is to trade the RSI divergence.

Divergence refers to a situation where the indicator readings do not support the movements in price.

Bearish divergence is established when price is moving higher, but the indicator is starting to move lower, suggesting that the market is losing bullish momentum and is vulnerable to a move lower.

Bullish divergence is established when price is moving lower but the indicator is moving higher, suggesting that the market is losing bearish momentum and is vulnerable to a move higher.

 

So, we have now looked at several key technical analysis methods and how they operate.

One of the big problems that many new traders face when using technical analysis is that they often find their trading ideas do not work out.

Even when taking trades that match the examples they have learned from; it can be incredibly frustrating to see these trades fail.

The driver behind a lot of these failed trades is firstly, traders attempting to take every setup they see, such as trading every test of support or resistance or every test of a trend line.

While these setups are valid, no trading strategy has a 100% hit rate and it is the job of the technical trader to hone and improve their strategy to increase their chances of success.

The most effective way of doing this is to establish technical confluence between different elements. While trading a test of support or resistance or a key Fibonacci level is a perfectly valid trade, it isn’t necessarily a high probability trade.

Your chances of success will be greatly increased if two or more technical elements coincide in the same price zone.

This technical confluence makes the trade idea much stronger and adds extra weight to the setup. So, let’s take a look at some examples and walk through how we can establish technical confluence in the market.

Fibonacci Retracements with Candlestick Setups

Trading Fibonacci retracement levels is a fantastic technical approach. The method is extremely simple and offers a fantastic way of gaining entry to trend markets where price is correcting with a dominant move. However, one of the big problems many new traders face is knowing at which level to enter.

One way of determining which level to trade is by waiting for price action confirmation using pin bars.

Knowing that pin bars reflect a shift in sentiment and suggest the potential for a reversal, the presence of a pin bar at a key Fibonacci retracement level flags up the likelihood of price reversing from that level.

This helps create a confirmation process for taking a trade whereby the trade monitors the market as it retests the Fibonacci retracement level and then only take a trade if a pin bar sets up, suggesting a forthcoming reversal at that level.

 

In the example above, you can see price correcting against a bullish move, moving lower until it tests the 61.8% retracement. At that point we see a bullish pin bar.

This tells us there has been a shift in sentiment at the level and flags the risk of a reversal higher, allowing us to place a buy trade as price breaks above the pin bar high.

Support & Resistance with Candlestick Setups

We’ve just looked at how we can use the presence of the pin bar in conjunction with Fibonacci retracements in order to establish which level to trade at.

Pin bars can also be used with other technical elements and are particularly effective with support and resistance.

One of the key complaints many new traders have when trading support and resistance level is price not respecting level. Again, it is important to note that no technical levels work 100% of the time. And again, we are always trying to strengthen our trade ideas and improve our chances of success.

So, in the same way as we did with the Fibonacci retracement, we can look to identify the presence of a pin bar at a support or resistance level to strengthen our chances of success with the trade.

This also gives us a solid trading strategy because instead of simply trading price each time it tests a support or resistance level, we can now look to only take a trade if we see a pin bar at the level.

 

In this example we can see that we have a solid support level in place, identified by the presence of three big swing lows from which point the market saw strong demand taking price back up higher.

So, with our support level established, we then need to simply monitor price as it retests the level. If we see a pin bar we can take a trade.

As you can see in this example, price formed a large bullish pin bar at the level from which we saw a strong bullish reversal. The presence of the pin bar at the level tells us there has been a shift in sentiment and alerts us to the prospect of a bullish reversal.

This allows us to enter a buy trade as price breaks above the pin bar high. Had there been no pin bar at the level we would not have taken the trade.

Adding in An Extra layer of Confluence (Combining three indicators)

We have already looked at how effective it can be to combine two technical elements, now it’s time to move onto a more advanced approach which is to combine three technical elements.

This is a method that will appeal to the more conservative traders as it creates an extra set of criteria to be met in order to take a trade.

Support & Resistance, Pin Bar, RSI Divergence

Keeping with the example we just looked at, trading a pin bar at a support level, one way of adding in extra confluence would be to look for the presence of bullish RSI divergence at the level.

So, let’s think about this as a process. Firstly, we highlight a support level in the market which is a pace we know can yield bullish reversals, offering a trade opportunity.

We then look to establish the presence of a bullish pin bar as we know this is a candlestick that suggests there has been a bullish shift in sentiment and alerts us to the potential for a bullish move.

Finally, we can then look to check the RSI indicator to see if there is bullish divergence. We know that if price is moving lower and the indicator is moving higher, this suggests bearish momentum is failing and alerts us to the chance of a bullish reversal.

 

So, let’s look at the example again but this time with the RSI indicator turned on. Now we can see that as price tested the support level, not only did we have a bullish pin bar, but we also had bullish RSI divergence with the indicator moving higher as price moved down to test the level.

So, we now have three layers of technical confluence alerting us to the potential for a bullish move from the level, strengthening our conviction to take the trade.

Conclusion

Hopefully by now you can see the benefits of establishing technical confluence.

Not only will it make your trading more structured by giving you specific criteria that need to be met in order to take a trade, it will also help you identify much better setups and increase your chances of success.

The best thing to do now is spend some time trying out combinations between different elements, looking at other candlestick formations, other indicators etc and finding what works best for you.

 

Author Profile

James Harte

James Harte

With over 6 years’ experience analysing currency markets, James is now a well-known industry analyst focusing on price action trading and fundamental drivers. Beginning as a private retail trader, James developed a strong interest in understanding the fundamental aspect of the market before pursuing technical trading capabilities which he now uses to identify opportunities over a short-term horizon. Alongside his market experience, James is also IMC certified having achieved the qualification to help further his understanding not only of the markets but the industry as a whole.

James has a strong interest in both fundamentals and technicals and uses both forms of analysis in generating and executing trade ideas, with trades generally lasting from a few hours to a few days.

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