A Trader's Guide To Using Fractals _ Investopedia.pdf

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5/31/2016 A Trader's Guide To Using Fractals | Investopedia

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Many people believe that the markets areany people believe that the markets arerandomandom. In fact, one of the most prominentIn fact, one of the most prominent

investing books out there is "A Random Walk Down Wall Street" (1973) by Burton G.nvesting books out there is "A Random Walk Down Wall Street" (1973) by Burton G.

Malkiel, who argues that throwing darts at a dartboard is likely to yield results similar toalkiel, who argues that throwing darts at a dartboard is likely to yield results similar to

those achieved by a fund manager (and Malkiel does have many valid points).hose 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 inowever, many others argue that although prices may appear to be random, they do infact follow a pattern in the form ofact follow a pattern in the form oftrendsrends. One of the most basic ways in which tradersOne of the most basic ways in which traders

can determine such trends is through the use ofan determine such trends is through the use offractalsractals. Fractals essentially breakFractals essentially break

down larger trends into extremely simple and predictableown larger trends into extremely simple and predictablereversaleversalpatterns. This articleatterns. This article

will explain what fractals are and how you might apply them to your trading to enhanceill explain what fractals are and how you might apply them to your trading to enhance

your profits.our profits.

What Are Fractals?hat Are Fractals

When many people think of fractals in the mathematical sense, they think of chaoshen many people think of fractals in the mathematical sense, they think of chaos

theory and abstract mathematics. While these concepts do apply to the market (it beingheory and abstract mathematics. While these concepts do apply to the market (it being

a nonlinear, dynamic system), most traders refer to fractals in a more literal sense. Thatnonlinear, dynamic system), most traders refer to fractals in a more literal sense. That

is, as recurring patterns that can predict reversals among larger, more chaotic prices, as recurring patterns that can predict reversals among larger, more chaotic price

movements.ovements.

These basic fractals are composed of five or more bars. The rules for identifyinghese basic fractals are composed of five or more bars. The rules for identifying

fractals are as follows:ractals are as follows:

A bearish turning point occurs when there is a pattern with the highest high in thebearish turning point occurs when there is a pattern with the highest high in the

middle and two lower highs on each side.iddle and two lower highs on each side.

A bullish turning point occurs when there is a pattern with the lowest low in thebullish turning point occurs when there is apattern with the lowest low in the

middle and two higher lows on each side.iddle and two higher lows on each side.

The fractals shown in Figure 1 are two examples of perfect patterns. Note that manyhe 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 thether less perfect patterns can occur, but the basic pattern should remain intact for the

fractal to be valid.ractal to be valid.
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Figure 1igure 1

The obvious drawback here is that fractals arehe obvious drawback here is that fractals arelagging indicatorsagging indicators- that is, a fractal can'tthat is, a fractal can't

be drawn until we are two days into the reversal. While this may be true, moste drawn until we are two days into the reversal. While this may be true, most

significant reversals last many more bars, so most of the trend will remain intact (as weignificant reversals last many more bars, so most of the trend will remain intact (as we

will see in the example below).ill see in the example below).

Applying Fractals to Tradingpplying Fractals to Trading

Like many tradingike many tradingindicatorsndicators, fractals are best used in conjunction with other indicatorsfractals are best used in conjunction with other indicators

or forms of analysis. Perhaps the most commonr forms of analysis. Perhaps the most commonconfirmationonfirmation indicator used withndicator used with

fractals is the "Alligator indicator", a tool that is created by usingractals is the "Alligator indicator", a tool that is created by usingmoving averagesoving averages thathat

factor in the use of fractal geometry. The standard rule states that all buy rules are onlyactor 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 validalid if below the "alligator's teeth" (the center average), and all sell rules are only valid

if above the alligator's teeth.f above the alligator's teeth.

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

Figure 2igure 2

As you can see, the primary drawback to this system is the larges you can see, the primary drawback to this system is the largeswingswings that takehat take

place. Notice, for example, that the latest fractal had alace. Notice, for example, that the latest fractal had adrawdownrawdown of over 100 pips andf over 100 pips and

still has not hit an exit point. However, there are countless other techniques that can betill has not hit an exit point. However, there are countless other techniques that can be
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applied in conjunction with fractals to produce profitable trading systems.pplied in conjunction with fractals to produce profitable trading systems.

Figure 3 shows aigure 3 shows aforexorex trading setup that uses a combination of fractals (multiple timerading setup that uses a combination of fractals (multiple time

frames),rames),Fibonacciibonacci-based moving averages (placed at 89, 144, 233, 377 and theirbased moving averages (placed at 89, 144, 233, 377 and their

inverses) and a momentum indicator. Let's look at a recent trade setup for thenverses) and a momentum indicator. Let's look at a recent trade setup for the

GBP/USD currency pair to see how fractals can help:BP/USD currency pair to see how fractals can help:

Figure 3igure 3

Here is a basic rule setup that is used when using a chart with a four-hour time frame:ere 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 afternitiate a position when the price has hit the farthest Fibonacci band, but only after

a daily (D1) fractal takes place.daily (D1) fractal takes place.

Exit a position after a daily (D1) fractal reversal takes place.xit a position after a daily (D1) fractal reversal takes place.

Notice how the fractals pinpoint meaningful tops and bottoms? This helps to take theotice how the fractals pinpoint meaningful tops and bottoms? This helps to take the

guesswork out of deciding at which Fibonacci level to trade - all we have to do is checkuesswork out of deciding at which Fibonacci level to trade - all we have to do is check

to see if the daily fractal occurred. We should also note that the trend strength begano see if the daily fractal occurred. We should also note that the trend strength began

increasing at the sell fractal, and topped at the buy fractal. Although we lose some pipsncreasing at the sell fractal, and topped at the buy fractal. Although we lose some pipswith the confirmation, it saves us from losing out on mere marketith the confirmation, it saves us from losing out on mere marketnoiseoise- 139 pips139 pips

certainly isn't bad for three days! (For further reading, seeertainly isn't bad for three days (For further reading, seeTrading Without Noiserading Without oise.))
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Things to Considerhings to Consider

Here are a few things to remember when using fractals:ere are a few things to remember when using fractals:

They are lagging indicators. They are best used as confirmation indicators to helphey 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 beonfirm that a reversal did take place. Real-time tops and bottoms can be

surmised with other techniques.urmised with other techniques.

The longer the time period (i.e. the number of bars required for a fractal), thehe longer the time period (i.e. the number of bars required for a fractal), the

more reliable the reversal. However, you should also remember that the longerore reliable the reversal. However, you should also remember that the longer

the time period, the lower the number of signals generated.he time period, the lower the number of signals generated.

It is best to plot fractals in multiple time frames and use them in conjunction witht is best to plot fractals in multiple time frames and use them in conjunction with

one another. For example, only trade short-term fractals in the direction of thene another. For example, only trade short-term fractals in the direction of the

long-term ones. Along these same lines, long-term fractals are more reliable thanong-term ones. Along these same lines, long-term fractals are more reliable than

short-term fractals.hort-term fractals.

Always use fractals in conjunction with other indicators or systems. They worklways use fractals in conjunction with other indicators or systems. They work

best as decision support tools, not as indicators on their own.est as decision support tools, not as indicators on their own.

Conclusiononclusion

As you can see, fractals can be extremely powerful tools when used in conjunction withs 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 mostther indicators and techniques, especially when used to confirm reversals. The most

common usage is with the "Alligator indicator" however, there are other uses too, asommon usage is with the "Alligator indicator" however, there are other uses too, as

we've seen here. Overall, fractals make excellent decision support tools for any tradinge've seen here. Overall, fractals make excellent decision support tools for any trading

method.ethod.

Resourcesesources

These are the two main charting packages that contain fractals:hese are the two main charting packages that contain fractals:

MetaTraderetaTrader for forexor forex

TradeStationradeStation for equities (via plug-in)or equities (via plug-in)

If you want to know more about chaos theory and its applications in the marketplace,f you want to know more about chaos theory and its applications in the marketplace,

an excellent book on the topic is "n excellent book on the topic is "Profiting From Chaos" (1994) by Tonis Vaga.rofiting From Chaos" (1994) by Tonis Vaga.
http://www.tradestation.com/http://www.metaquotes.net/

A Trader's Guide To Using Fractals _ Investopedia.pdf

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