Fractals in trading

 

What are fractals?

Fractal geometry, defined by mathematician Benoit Mandelbrot,  is a geometric figure that can be decomposed into parts, each one of these parts identical on a smaller scale to the original figure. However, the "fractal finance" applied to technical analysis is a geometric pattern that can be observed regardless of the time frame used, either 1 hour, 30, 15 or 1 minute. There are some books on this subject and one of the most popular is "Trading Chaos" that was written by Dr. Bill Williams. In this book, Dr. Williams entered two important concepts, the  "Fractal UP" and "Down Fractal",  which can be used as support and resistance respectively.  When both formations are crossed by the price, that indicate new levels for prices in both bull and bear markets.

The "Fractal Up" (it indicates a possible resistance), defined by Williams (Using a bar chart) is one pattern where the central bar has a maximum price that is greater than the maximum of the two bars to the right and higher than the maximum of the two bars on the left. On the other hand, the "Fractal Down" (it indicates a  possible support) is one pattern where the central bar has a minimum price that is less than the minimum of the two bars to the right and less than minimum of two bars on the left. We can observe the ideal fractal in the image:
Bullish and Bearish Ideal Fractals
However, there are different patterns that can be used, such as:

Main types of Fractals

Fractal characteristics

  • Fractals shall be composed of at least 5 bars . It's like our hand. The middle finger is higher than the two fingers on the right and the two fingers on the left. If we turn our hand with the middle finger perpendicular to the ground, then we have the middle finger lower than theto two fingers on the left and the two right fingers.
  • Fractals are present in every movement in the market, both bull and bear markets.
Fractals are important to draw trend lines in the Forex market. When we draw a line between  two fractals we can identify key supports and resistances in the market. Fractals can be very useful combined with other indicators.

If we use the fractals in its pure form without any other indicator, the interpretation is as follows: 

How to interpretate fractals?

  1. A downtrend is indicated by a maximum candle/bar  or a group of maximum candles/bars having at least 2 lower maximum candles on each side of the formation.
  2. An uptrend is indicated by a minimum candle/bar  or a group of minimum candles/bars having at least 2 higher minimum candles on each side of the formation.
We can interpret the fractal as follows:
  • Formation of a downtrend: In this case the fractal form crests. Remember the hand?. The middle finger is the highest. A crest indicates that the price will go down.
  • Formation of an Uptrend: In this case the fractals form valleys Remember the hand with the middle finger pointing towards the ground at right angles?. A peak pointing down indicates that the price will go up.
In the trading plataform Metatrader 4 the fractal are used as an indicator as follows:

Fractals indicator on Metatrader 4. MT4 of FXOpen broker


*Each blue arrow represent the peak of a Fractal Up or a Fractal Down.

How to Trade Using Fractals?

Basically, fractals descomposes larger trends into very simple and predictable reversal patterns.The trader can use these patterns in the following ways.
  • Finding the market trend: In an uptrend a series of up fractals are broken more than the down fractals. the more bullish fractals are broken, the stronger the uptrend. In a down trend, a series of down (bearish) fractals are broken more than up fractals. In the forex chart below we note how we have been breaking down fractals in the USDCHF pair since the fractal at point C (August 6th 2007) to point D (September 30th 2007).
  • Identification of consolidating zones: It is easy using fractals to identify ranging or consolidating areas. If prices move up and down between up and down fractals and cannot seem to open above or below the most current up and down fractals, then the market is consolidated.
  • Identification of breakout points: One of the ways I use fractals is simply to use them as breakout points.This is especially true in the longer term forex trading charts. They especially work very well in daily ,240 min and 60 min charts. The rule of thumb is to wait for the price to open below a fractal and trade in that direction.
 
Like many other indicators, Fractal works best when used along with other indicators, so Williams proposed the "Alligator System", given the metaphor that Mr. Williams made when comparing the price movements with the movements of the mouth of this the animal. The system is based on fractals above and the use of three moving averages which can be associated with the movement of the alligator in the following way:
  • Alligator's Jaw (Jaw, blue line) - Moving Average 13 periods (High + Low) / 2, plotted 8 periods ahead.
  • Alligator's Teeth (Teeth, red line) - 8-period moving average (High + Low) / 2, plotted 5 periods ahead.
  • Alligator's Lips (lips, green line) - 5-period moving average (High + Low) / 2, plotted 2 periods ahead.
 

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