Fractals can be used effectively in forex trading, especially with the power of a mechanical trading system.
A fractal is a repetitive natural pattern
A fractal is a geometric shape or set of self-similar mathematical patterns found in nature. When broken into smaller pieces, fractal shapes exhibit the same shape or characteristics of the larger object.
In nature, fractal shapes and patterns may be observed in things such as broccoli and many other types of plants, where the smallest florets still have the same overall shape as the largest “head” of broccoli. Likewise, many mineral and crystal forms exhibit similar patterns on both large and small scales.
Price movements in marketplaces are often thought to be random and chaotic. Yet, as with other seemingly-random forms found in nature, fractal patterns can be observed in price charts of forex pairs and other assets. Forex price movements show certain repetitive fractal patterns which can be profitably traded.
Fractals used in forex trading may show the same form at every size scale, or they may show nearly the same form at different scales. Stated simply, in forex trading a fractal is a detailed, self-similar pattern that repeats itself, often many times over.
It’s important to note that these fractal patterns aren’t the regular, geometrically-square figures found in man-made structures; they don’t have sides with even-integer factors. The distinguishing characteristic of fractals in forex trading and elsewhere is their natural organic scaling when contrasted with ordinary geometric figures.
For example, doubling the length of one side of an ordinary geometric square will scale the area of that figure by four, since the square has 2 sides, and 22 equals four. Or, when a geometric sphere’s radius is doubled, the volume scales to eight, because the sphere has three dimensions, and 23 = 8.
In contrast, when the one-dimensional lengths of a fractal are doubled, the space contained within that fractal scales up by a number that is not a whole integer.
Leaving aside the mathematical and technical description of fractals — In essence, I use them in forex trading so that my mechanical trading system can break down larger “cluttered” price movements into very simple and highly predictable views of trends and reversals.
Once these trends are visible, it’s easy for my automated trading system to take advantage of them. In particular, I’ve found that fractal signals based on smoothed moving averages (SMMAs) are very valuable for trading when I use them together with momentum indicators.
How do fractals help with forex trading?
Fractals predict reversals in current trends. When viewed as a set of price bars on a chart, the most basic fractal pattern contains five bars or candlesticks with these characteristics:
1. When the lowest bar is positioned at the middle of a pattern, and two bars that have successively higher lows are located on each side of it, this signals the change from a downward trend to an upward trend;
2. When the highest bar is positioned at the middle of a pattern, and two bars that have successively lower highs are located on each side of it, this signals the change from an upward trend to a downward trend;
Stated differently, when the forex fractal pattern shows the highest high at the center, and there are 2 lower highs positioned at each side, it signals a bearish turning point. And, when the pattern has the lowest low at the center, and there are 2 higher lows positioned at each side, it signals a bullish turning point.
Fractals are lagging indicators, so a mechanical trading system can’t act on them until they’re a couple of bars into the reversal. Still, since most of the significant reversals last for multiple bars, the trend usually continues long enough for me to trade it.
Fractals work best for forex trading when used together with a momentum indicator. Along with fractal indicators, I also use an oscillator such as the CCI indicator to facilitate entering a forex trading position as early and safely as I can.
Fractal Alligator indicators
My favorite fractal tool is the “Alligator indicator,” which is a moving-average tool that relies on fractal geometry and SMMAs. This indicator with a fancy name was introduced by senior trader Bill Williams around 1995, and it’s commonly available in MetaTrader software.
If you’re using MetaTrader, you should be able to easily add this fractal indicator by clicking on the menu tabs “Insert,” then “Indicators,” “Bill Williams,” and “Fractals.”
Alligator indicator lines confirm the direction and presence of a trend. Specifically, the Alligator indicator consists of 3 smoothed moving averages. Overlaid on pricing charts, these balance lines represent the metaphorical “jaw,” “teeth” and “lips” of the Alligator.
Carrying the metaphor further, it can be said that when the 3 balance lines are intertwined or converged, the Alligator is asleep with its mouth is closed. This indicates that particular forex market is trading in a sideways range.
Once a trend forms, the Alligator awakens and it begins to “eat.” The Alligator isn’t a picky eater; it can feast on either a bull or a bear. Once satisfied, the Alligator’s mouth closes and the creature returns to sleep.
The Alligator fractal indicator shows trends in the following way: When the price is trading above the mouth of the Alligator, i.e. the green balance line is over the red line which is over the blue line, and all three are aligned and pointing upward, yet still below the price line, this indicator signals a clear uptrend.
Conversely, when the price moves below the Alligator’s mouth, and the blue line is over the red line which is over the green one, and all three of the balance lines are above the price line, then the indicator signals a downtrend.
Finally, once the fractal forex trading Alligator has sated itself, the green, red and blue balance lines once again converge and cross over, signaling the end of the trend. At that point, my mechanical trading system takes profits, and then begins to watch for the next fractal forex trading opportunity.
In short, my mechanical trading system filters fractal signals by stating that the buy rules are confirmed only if they signal a value below the “alligator’s teeth” in the pattern, which means the center average.
Likewise, my sell rules are only confirmed if they signal above the alligator’s teeth. As well, I double-confirm the validity of Alligator signals by using the CCI oscillator.
The fractal Alligator formula
The Alligator’s jaw, often depicted as a blue line, shows a Smoothed Moving Average containing 13 periods; this line is then moved 8 bars into the future;
The teeth, depicted with a red line, shows a Smoothed Moving Average containing 8 periods, moved 5 bars into the future;
The lips, depicted as a green line, shows a Smoothed Moving Average containing 5 periods, moved 3 bars into the future.
To reiterate, when the red and green balance lines cross over the blue line, it signals my mechanical trading system to “sell.” Conversely, when the red and green lines cross under the blue line, it signals a “buy.”
For purposes of programming a mechanical trading system for fractal forex trading:
- n is the number of periods
- High(n) is the highest price during period n
- Low(n) is the lowest price during period n
- SMMA(ABC) is a Smoothed Moving Average in which A is the data being smoothed, B is the period being smoothed, and C is the shift in time-period
The mechanical trading system calculates the balance lines:
- [Low(n) + High(n)] / 2
- SMMA (Median price n, 13, 8) = Alligator jaw (the blue line)
- SMM (Median price n, 8, 5) = Alligator teeth (the red line)
- SMM (Median price n, 5, 3) = Alligator lips (the green line)
Forex markets show many false trends. That is, often a “trend” may appear to begin, yet the price action soon settles back into a sideways range.
When using fractals, my strategy correctly identifies real trends and then follows them. Fractal forex tools such as the Alligator help my mechanical trading system reach through price clutter and focus on finding and trading the real trends.
My fractal trading method based on Alligator indicators
Here’s the simplest form of my fractal trading system based on Alligator indicators:
• Determine the entry point according to when the Alligator balance lines are intertwined, i.e. the Alligator is “sleeping” and when the CCI oscillator is indicating an overbought price condition;
• Execute new orders with 2% of the account equity;
• Places a stop-loss order at exactly 20 pips below the entry point;
• Sets an exit order to be triggered when more than two of the Alligator balance lines cross the candlesticks and/or when the CCI oscillator indicates an overbought condition.
Other ways to use fractals
Fractals are an easy way to see or confirm trends on any time frame. I program my mechanical trading system to check and see whether the fractals are showing lower lows and lower highs, or higher highs and higher lows. For my typical forex trading, I use fractals based on one-day, one-week, and one-month time frames.
The longer the time frame used to generate the fractal, the greater the reliability of the signals it produces. Also, the longer the time frame, the fewer the signals.
Also, I program my mechanical trading system to calculate fractals in order to set trailing stops. Since fractals show changes in trends, they work well to trigger my mechanical trading system to exit from trades when very-short-term reversals threaten to eat up the profits from a trade.
Trading with fractals and Fibonaccis
Beyond using the fractal Alligator indicator, fractal tools offer a great way to confirm Fibonacci signals. I’ve found that fractal forex trading works well when used for Fibonacci retracement levels.
I program my mechanical trading system to draw Fibonacci bands and calculate the fractals using daily time frames in forex markets such as EUR/USD and GBP/USD.
Then, I open a position when the price touches the most-distant Fibonacci band, yet only after my mechanical trading system sees that a daily (D1) fractal signal has occurred. The mechanical trading system exits the trade when a D1 fractal reversal occurs.
When using Fibonacci tools, fractals help pinpoint tops and bottoms with great accuracy. This gives me the confidence to trade at the right Fibonacci level. It’s easy – My mechanical trading system simply looks for the daily fractal parameter.
General considerations when using fractals
In order to double-check the signals generated from fractal indicators, my mechanical trading system uses other indicators such as the CCI oscillator to confirm fractal signals before trading. And, as with any type of trading method, use appropriate risk management measures to ensure that drawdowns are reasonable.
Fractals can be plotted in multiple time frames and used to confirm each other. One simple rule is to only trade short-term fractal signals in the direction of long-term fractal signals, since long-term fractals are the most reliable. Use another indicator for safety such as the CCI oscillator to confirm the signal.
The Alligator and other fractal tools help
Fractals offer a set of powerful tools that you can use to strengthen your profits. Since mechanical trading systems are able to calculate fractal values and act on them quickly, there are plenty of fractal-based trading opportunities.
My own personal favorite is the Alligator indicator, yet fractals also work well with Fibonacci indicators and other trading strategies. In fact, fractal tools enjoy a relatively small yet devoted following among successful traders.
How do you use fractals in your trading? Share your thoughts on fractals below.
Source: Fractals in Forex Trading