a trader's guide to use fractals

8/12/2019 A Trader's Guide to Use Fractals

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A Trader's Guide To Using FractalsBy Justin Kuepper A A A

Related Searches: Stock Trading Software , Day Trading Software , Stock Charts , Free Forex Training , Free Forex Course Many people believe that the markets are random . In fact, one of the most prominent investing books out there is "A RandomWalk Down Wall Street" (1973) by Burton G. Malkiel, who argues that throwing darts at a dartboard is likely to yield resultssimilar to those achieved by a fund manager (and Malkiel does have many valid points).

However, many others argue that although prices may appear to be random, they do in fact follow a pattern in the form of trends . One of the most basic ways in which traders can determine such trends is through the use of fractals . Fractals essentially breakdown larger trends into extremely simple and predictable reversal patterns. This article will explain what fractals are and howyou might apply them to your trading to enhance your profits.

What Are Fractals?When many people think of fractals in the mathematical sense, they think of chaos theory and abstract mathematics. While theseconcepts do apply to the market (it being a nonlinear, dynamic system), most traders refer to fractals in a more literal sense. Thatis, as recurring patterns that can predict reversals among larger, more chaotic price movements.

These basic fractals are composed of five or more bars. The rules for identifying fractals are as follows:

A bearish turning point occurs when there is a pattern with the highest high in the middle and two lower highs on eachside.

A bullish turning point occurs when there is a pattern with the lowest low in the middle and two higher lows on each side.

The fractals shown in Figure 1 are two examples of perfect patterns. Note that many other less perfect patterns can occur, but the basic pattern should remain intact for the fractal to be valid.
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Figure 1

The obvious drawback here is that fractals are lagging indicators - that is, a fractal can't be drawn until we are two days into thereversal. While this may be true, most significant reversals last many more bars, so most of the trend will remain intact (as wewill see in the example below).

Applying Fractals to TradingLike many trading indicators , fractals are best used in conjunction with other indicators or forms of analysis. Perhaps the mostcommon confirmation indicator used with fractals is the "Alligator indicator", a tool that is created by using moving averages that factor in the use of fractal geometry. The standard rule states that all buy rules are only valid if below the "alligator's teeth"(the center average), and all sell rules are only valid if above the alligator's teeth.

Figure 2 is an example of such a setup:
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Figure 2

As you can see, the primary drawback to this system is the large swings that take place. Notice, for example, that the latestfractal had a drawdown of over 100 pips and still has not hit an exit point. However, there are countless other techniques that can

be applied in conjunction with fractals to produce profitable trading systems.

Figure 3 shows a forex trading setup that uses a combination of fractals (multiple time frames), Fibonacci - based movingaverages (placed at 89, 144, 233, 377 and their inverses) and a momentum indicator. Let's look at a recent trade setup for theGBP/USD currency pair to see how fractals can help:
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Figure 3

Here is a basic rule setup that is used when using a chart with a four-hour time frame:

Initiate a position when the price has hit the farthest Fibonacci band, but only after a daily (D1) fractal takes place. Exit a position after a daily (D1) fractal reversal takes place.

Notice how the fractals pinpoint meaningful tops and bottoms? This helps to take the guesswork out of deciding at whichFibonacci level to trade - all we have to do is check to see if the daily fractal occurred. We should also note that the trend


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strength began increasing at the sell fractal, and topped at the buy fractal. Although we lose some pips with the confirmation, itsaves us from losing out on mere market noise - 139 pips certainly isn't bad for three days! (For further reading, see TradingWithout Noise .)

Things to ConsiderHere are a few things to remember when using fractals:

They are lagging indicators. They are best used as confirmation indicators to help confirm that a reversal did take place.Real-time tops and bottoms can be surmised with other techniques.

The longer the time period (i.e. the number of bars required for a fractal), the more reliable the reversal. However, youshould also remember that the longer the time period, the lower the number of signals generated.

It is best to plot fractals in multiple time frames and use them in conjunction with one another. For example, only tradeshort-term fractals in the direction of the long-term ones. Along these same lines, long-term fractals are more reliable thanshort-term fractals.

Always use fractals in conjunction with other indicators or systems. They work best as decision support tools, not asindicators on their own.

ConclusionAs you can see, fractals can be extremely powerful tools when used in conjunction with other indicators and techniques,especially when used to confirm reversals. The most common usage is with the "Alligator indicator"; however, there are otheruses too, as we've seen here. Overall, fractals make excellent decision support tools for any trading method.

ResourcesThese are the two main charting packages that contain fractals:

MetaTrader for forex TradeStation for equities (via plug-in)

If you want to know more about chaos theory and its applications in the marketplace, an excellent book on the topic is "ProfitingFrom Chaos" (1994) by Tonis Vaga.
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a trader's guide to use fractals

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