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Fractals: what are they and how to use them

By Neil Dennis

08:48, 14 March 2018

fractal

Fractals belong in the more abstract bracket of mathematics and are used in trading to help identify points in a chart where a reversal looks likely.

Traders may use fractal signals to decide where to place stop loss orders and other settings on their trading platform.

What is a fractal?

As is often the case in mathematics, the more abstract the concept, the more difficult are the sums and equations to define it.

Let's assume, then, that most readers of this article are not mathematical experts and try to describe the nature of a fractal without the need for complex maths.

Simply put, a fractal is an object - naturally occurring or artificially generated - that exhibits replicating patterns at increasingly small scales.

Fractals can occur naturally. Snowflakes, for example, exhibit fractal repetitions on each arm of the ice crystals that form them.

snowSource: Shutterstock

Look at the romanesco broccoli below and how its individual florets repeat each other, getting smaller and smaller and appearing to weave a spiral down to the very tip of the vegetable.

broccoliSource: Pixabay

Meanwhile, graphic artists use computer-generated fractals to develop some stunning images or works of art that display replicating patterns of immense complexity.

fractalSource: Pixabay

Bill Williams

US trader Bill Williams is the author of several books on trading philosophies and technical analysis. He has often used a closely-related topic - chaos theory - and fractals in trading financial markets.

His theory cannot be considered to be watertight - what trading theory can? - but it can be seen to work many times over when studying historical charts.

Here's how it works:

Fractals can be seen forming on charts of any asset price. You must have charts capable of technical analysis, set to candlestick mode. Fractals form over at least five bars on a candlestick chart - representing five consecutive sessions of price movements.

Up fractal

An up fractal is formed when a single candle has two candles to the right of it showing lower highs and at least two candles to the left of it also showing lower highs.

fractal3Source: Neil Dennis/Capital.com

The chart above shows:

XRP/USD

0.60 Price
+0.410% 1D Chg, %
Long position overnight fee -0.0753%
Short position overnight fee 0.0069%
Overnight fee time 22:00 (UTC)
Spread 0.01168

Gold

2,083.15 Price
+1.890% 1D Chg, %
Long position overnight fee -0.0191%
Short position overnight fee 0.0108%
Overnight fee time 22:00 (UTC)
Spread 0.50

Oil - Crude

79.49 Price
+1.850% 1D Chg, %
Long position overnight fee 0.0265%
Short position overnight fee -0.0484%
Overnight fee time 22:00 (UTC)
Spread 0.030

BTC/USD

62,651.85 Price
+1.970% 1D Chg, %
Long position overnight fee -0.0616%
Short position overnight fee 0.0137%
Overnight fee time 22:00 (UTC)
Spread 106.00
  1. The centre point of the fractal
  2. At least two candles to the left with lower highs
  3. Two candles to the right showing lower highs

Down fractal

Conversely, a down fractal is formed when a single candle has two candles to the right of it showing higher lows and at least two candles to the left of it also showing higher lows.

fractal5Source: Neil Dennis/Capital.com

The chart above shows:

  1. The centre point of the fractal
  2. At least two candles to left with higher lows
  3. At least two candles to the right with higher lows

Fractals trading

We're going to look at some similar charts below, but these have a slight difference. On each of the two candlestick charts, there's a breakout candlestick that establishes either a buy or a sell signal.

But first, let's make it clear - the fifth candle must close before making a trading decision, otherwise you might make an error based on an incomplete fractal.

Breaking that fractal

Traders, then, are looking for broken fractals. Once the fractal has been formed, look for the sixth bar to break out.

If the sixth bar following an up fractal breaks above the centre point of the fractal, this is considered a bullish signal.

fractal5Source: Neil Dennis/Capital.com

The chart above shows:

  1. The centre point of the up fractal
  2. The lower highs to the left, and,
  3. The lower highs to the right that complete the fractal
  4. The next candlestick breaks above 1. to provide a buy signal

As the chart shows, this would have been a particularly successful buy signal, depending on where the trader decided to take their profit.

Conversely, if the sixth bar following the formation of a down fractal breaks below the central point, this is considered a bearish indication.

fractal6Source: Neil Dennis/Capital.com

The chart above shows:

  1. The centre point of the down fractal
  2. The higher lows to right and the
  3. Higher lows to the left
  4. The next candlestick in the sequence breaks below 1. to provide a sell signal or indicate a shorting opportunity (speculating on falling prices)

Limitations

Fractals can be useful indicators, but don't always follow the pattern suggested above. Because they are lagging indicators they can only really ever confirm a reversal took place at the point of breakout.

And, of course, the longer you wait for confirmation of the breakout and reversal, the opportunity for trading profitably narrows.

Therefore, many traders will say fractals are only of particular use in conjunction with other technical indicators such as moving averages.

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