Trading with Fractals

One of the central discussions that is had in market internet forums involves the validity of technical analysis and whether or not it should be used at all when compared to fundamental analysis. A large part of these discussions deal with arguments suggesting that markets are random, and cannot be predicted using historical price activity. The popularity of this debate has helped authors like Burton Malkiel rise in popularity. Malkiel’s A Random Walk Down Wall Street essentially argues that investing in the financial markets can be done with no greater probability than throwing darts at a dartboard.

But while there are many valuable truths in Malkiel ‘s assertions, the underlying belief that markets are inherently unpredictable can be quickly disproved by the large number of traders that successfully employ price strategies and are able to generate gains on a consistent and long term basis.

Do Historical Patterns Actually Exist?

Those that disagree with the idea that markets are random and chaotic will often cite the tendency for markets to unfold in patterns and then proceed in a way that can then be predicted with a certain degree of probability. Price patterns give traders the ability to identify the underlying trend, the strength of that trend, and the likelihood with which that trend is likely to extend or reverse. One relatively simple way traders can assess these trends is to use fractals, which can deconstruct the larger trends and point out potential reversal patterns. So, what exactly is a fractal — and how can it be used in active trading?

Fractals Defined

The traditional use of the term “fractal” deals with mathematics and chaos theory. But the term can be applied to the financial market as well, given the fact that it is a non-linear, dynamic system. Traders tend to simplify these ideas when moving in and out of active positions, and see fractals as periods of minor retracement within larger trends. A tutorial for adding the fractal indicator to your MetaTrader platform can be found here.

The spatial structures themselves consist of five or more price intervals (or at least five candles on a candlestick chart). These price periods must then meet the following criteria:

Bullish fractal reversal points are found when the pattern low is surrounded by at least two higher lows on both the right side and left side. In the example below, the fractal itself is shown as a red arrow.

Bearish fractal reversal points are found when the pattern high is surrounded by at least two lower highs on both the right side and left side.

Finding Tops and Bottoms with Lagging Indicators

Traders that argue against the use of fractals might cite the fact that they are lagging indicators. In order for the fractal pattern to complete itself, we will need to see reversal activity in at least two price periods. For example, in a bullish reversal prices need to rise for at least two time intervals. This means that there is no way to place a trade entry at the lowest low before the uptrend begins.

But the fact remains that most true reversals will need more than two time intervals to unfold — sometimes many more than two. This means that fractal reversal strategies are excellent structures for those seeking strong risk-to-reward ratios, as stop losses can be placed just outside of the reversal structure. And even with the delay of two time intervals, an extended reversal will create a scenario where you can still place a trade entry while most of the new trend remains intact.

Related Indicators

In practice, traders rarely use the fractal indicator on its own. One related indicator that combines the use of fractals along with moving averages is the Alligator indicator. In the chart below, we can see that buy signals are sent when prices are able to break above the Alligator teeth (the center line in the moving-average cluster). Sell signals are sent when prices break below the Alligator’s teeth. See below:

When combining indicators, the traditional rules of technical analysis require us to play to the strengths of all available tools and to weed-out conflicting signals (i.e. avoid placing a trade). If we are using fractals along with the Alligator indicator, we will need to see a fractal signal that agrees with how prices are behaving relative to the Alligator reading. So if we are looking to enter short positions, we would need to see a bearish fractal form as prices start to penetrate the Alligator teeth from above. The reserve would need to be true in order to initiate buy positions.

Essential Elements

From the link above, we can see that it is relatively easy to install a fractal indicator on your charts and then to spot the patterns once they develop. But there are some essential elements that should be remembered when actual trades are being placed. Since a fractal is a lagging indicator, it is a good idea to use them as a way of confirming outside signals. This will help you to understand whether or not a true reversal is actually unfolding — and whether or not a trading position should actually be taken.

Time Frames

In this article, we reference “time intervals” but this is just a fancy way of describing the single plotted price points in your charts. If you are using an hourly candlestick chart, this is one price bar (wicks included). But fractal techniques are most effective when dealing with broader time horizons. So if you are using a daily or weekly price chart, your fractal signals will indicate the potential for a more reliable reversal. Traders with reduced time availability tend to operate using the broader time frames and the added advantage here is that you receive fewer signals that have higher probabilities for accuracy.

It is also important to use more than one temporal perspective when you define your bias. This means multiple charts for the same asset. What is happening over the hourly interval? What is happening over the daily interval? Your chances of trading success will improve if these areas agree with one another. But there are also contrarian arguments that can be made when the longer-term perspective disagrees with the short-term view. If markets are up this week in a long term downtrend, it makes sense to take advantage of your environment and start to build selling positions (and vice versa).

Conclusion: Fractals Should be Used as Confirmation for Established Trend Signals

Situations like these are where fractals can be great for active traders that already have an established bias. If you see a fractal on your chart when you have a prepared trading strategy, its usually time to pull the trigger as you will be given your confirmation. It is most important to remember that fractals should be used as potential reversal signals. This means that fractals can be used to either open or close positions. For example, if you are currently buying an asset, it might be a good idea to close the position if you see a bearish fractal form as the Alligator indicator is suggesting a potential move to the downside. So these tools can be used in dynamic ways in multiple strategies, and they should not be viewed as unilateral indicators that have only one application.

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