In the methodology presented on this blog the term Fractal comes up all the time. It is found in the About section of Fractal-Trading as part of an entry strategy. More precisely, it defines breakout points where the trendfollower finds a good time and place to buy or sell, depending on if it’s an up- or downfractal.
Fractals can have many forms, as the chart below indicates. It shows up- and downfractals, which signal either a buying or a selling opportunity for the trader. The fractal consists of at least five bars, where the middle one is highest/lowest. Originally, Bill Williams of the Profitunity Trading Group (PTG) came up with determining a fractal dimension in financial markets. Spurred on by Bernot Mandelbrot, who was looking at the fractal dimension of nature, in sociology, psychology and finance, Bill Williams buildt a Trading System around the idea that markets are a natural function, not a man-made, artificial place of trading. It is rather based on the behavior of its participants – the traders, investors, institution, all of whom are subject to their own irrational fears, greed and other emotions. These different behaviors of its participants will eventually lead to price changes and different phases of markets. Most commonly one would distinguish between an uptrending, downtrending or sideways-moving market. The fractal dimension in the latter is extremely high. This means that many fractals occur all the time, usually two of them – one on the upside and one on the downside – will mark the outer support and resistance areas of the sidemoves. Inside these borders dozens of fractals can occur, they makre up the choppy nature of a market. In an up- or downtrend however, the fractal-dimension is a low one, with only very few fractals occuring along the way of the trend. Most of the time an intitiating fractal, which the trendfollower uses to get his first position into the market on a breakout trade, occurs, and is only followed by one or two more fractals after internal corrections have finished.
(Fractals in a price chart)
Bill Williams takes this further and argues, that the underlying structure of the market is the Elliott Wave, and that the Elliott Wave consists of Fractals. Meaning that between every Fractal, an Elliott Wave of some degree was going on. This also makes for the conclusion that every fractal is a change of behavior of the market participants. As soon as enough volume in a market changes its mind, the market turns – either, by the theory of Elliott Waves, in the shape of an internal correction during an ongoing trend, or for a big trendreversal. In a sideways-movement of the market endless fractals occur, simply because there is no direction to the market, it trades on top of the moving averages (Alligator) and therefore remains in the balance zone. This is where the price stays 60-70% of the time, bouncing around between the upper and lower fractal border of the sidemove, creating many more “changes of behavior” inside of this zone. Until a greater new desicion has formed inside of the mass of market participants and one of the fractal borders (upper/lower) is actually broken, the market remains undecided on where to head next, and is therefore an unhospitable environment for the trendfollower. The key is to learn to distinguish between random fractals inside a sideways-movement, and the “greater” fractals, which trigger a new, major market movement.
Even though the PTG has come up with a pretty decent way to count the Elliott Wave, Fractal-Trading has not found it to be too helpful in real-time trading to know in which wave you are. The most obvious waves, such as wave 3 and wave 5 – which are also the ones yielding the most profits in an upmove – are the ones where the trendfollower is active in the market anyway. Paying some attention to the increasing pressure to the up- or downside via the Momentum Oscillator (AO) can help to find out what wave is currently underway. In case the market turns into a correction, Fractals are enough to take care of an entry into a trend-reversing scenario. There is no need to find out where wave 5 ended, there is also no need to project price targets on certain waves.
Reducing the system to using Fractals and playing around with the trendlines/moving averages/Alligator, already makes for a very nice trading system that has shown great results when backtesting it. Just as trendfollowing suggests to keep it simple and focus on the process in order for the results to be fruitful automatically, the Bill Williams Trading System can be reduced to fit this philosophy perfectly.
Why are Fractals the best way to determine distinguishable breakout points? Simply put, they are generated directly from price action, in the moment of now of the market without any questions asked. The fractal is either there, or it isn’t. There is no discussion or interpretation whether it is “true” or “valid” or if you should “skip” it or “wait for the next one.” It is also not an indicator that calculates an average of another average for a new kind of measurement providing a signal. The fractal is also not just some candlestick #X where we usually enter. It is the most precise point in time and point of price where market participants have changed their minds – they decided price should stop going down and start to go up (or vice versa). If price now exceeds that change of mind in the other direction, the trendfollower has a buy/sell opportunity. Please see the chart below for illustration.
Keep following my blog to see how Fractals play out as entry and addon signals for major trends, both on daily and weekly charts.
Williams, Bill: Trading Chaos 2nd Edition. John Wiley & Sons (2004).
My own research and experiences regarding changes of the original PTG system.