Trading Forex with Fractal Strategies

[RichardCox 10]

Trading Forex with Fractal Strategies

 

The concept of fractals is something that can be applied to a wide variety of events and activities throughout the universe, and the fact that they are so prevalent is why many traders in the financial markets use fractals in their analysis. These ideas are somewhat complicated but fractals are essentially geometric patterns that repeat in increasingly smaller scales. These patterns create irregular shapes and structures that cannot be recreated using classical geometry.

 

When applied to the forex markets, one of the most common approaches is to apply fractals to consolidation patterns and price channels. Those price channels and consolidation zones are then expected to act as support and resistance boundaries that can be used to establish trade entries when used in conjunction with other technical signals and indicators. The rationale for these trading decisions is based on the fact that since fractals appear broadly in nature, the patterns are expected to be repeatable in terms of what can be expected in market activity, as well. So, for example, any time you see a pattern repeating on a 5-minute chart, you will likely find similar patterns developing on the longer term time frames. In this way, it can be argued that fractal formations have some key attributes in common with patterns that are derived from the Fibonacci sequence.

 

Fractals vs Basic Price Channels

 

One distinction that should be understood is that there are differences between fractal formations and basic price channels. For the most part, there are two main differences. First, fractals can give more information than simple price channels in determining broader price trajectory. When fractals are layered upon one another, it becomes much easier to determine the trend and to forecast the distances price will travel once it breaks out of the fractal zone. So for example is there are 40 pips between the top and bottom of the fractal zone, it would be likely that prices would travel about 40 pips once price breaks out of the fractal zone (in either direction). This information can be very useful when setting stop losses and profit targets for your trades.

 

Second, fractals are most useful in clarifying the price dynamics that are present in the market at any given moment. Once you have more experience constructing price fractals, it becomes easier to identify impulse moves in the market that are likely to determine the trends that follow. The central market activities that create the fractal formations require significant order flows (on the level of order flows that are generated by major financial centers like institutional banks and currency fund traders). For these reasons, fractals help traders identify moves that are likely to dictate the direction seen in upcoming trends.

 

Chart Examples

 

Now that we understand the basic rationale behind fractal strategies, it is a good idea to look at some visual examples of how these structures form on a price chart. Most of the larger trading platforms can automatically plot fractals for you. But here, we will do these manually so that we can identify some specific areas that highlight the logic behind the fractal trading strategy.

 

 

In the chart above, we can see prices in a short term downtrend that is marked by three separate fractal formations (shown with downside arrows). Each of these price zones is worth about 50 pips and prices moved back in a more sideways direction once this series had run its course. We can also see that a bullish fractal occurred before the reversal came, and this change could have been spotted by traders that were watching for the price zones themselves to start breaking down. Once a trader could see that the 50 pip series was no longer valid, profits could have been taken on short positions and new long positions could have then been established.

 

In this way, fractal formations can be much more valuable than simple price channels in determining potential trend direction and the eventual reversal. When we use basic price channels by themselves, it is much more difficult to identify profit targets because there is no association with actual pip values. In the chart above, traders would be able to identify profit targets in 50 pip increments. Basic price channels themselves would have only given traders an idea of the trend direction without any indication of which price level would be optimal for taking profits on short positions. It should also be noted that these fractal zones work as resistance zones as prices are moving lower. This is another area that is not possible to identify when using simple price zones (because for this you would need the pip values that are generated by the fractal formations).

 

 

In the next chart, we can see prices in a short term uptrend that is marked by four separate fractal formations (shown with upside arrows). Each of these price zones is worth about 100 pips and this was followed by price activity moving in a more sideways direction after this series had run its course. We can also see that a bearish fractal occurred before that reversal, a signal that could have been used to close out long positions already established. In the chart above, traders would be able to identify profit targets for long positions in 100 pip increments.

 

We can also see that the fractal zones work as support zones as prices are moving higher. In this way, the fractal zones will actually work as resistance turned support levels that can be used to determine whether or not the initial bullish trend has run its course and is ready to reverse.

 

Trading Tips

 

With these examples, we can see that fractals make it easier to separate trends using definable price zones. From a fundamental perspective, this makes a good deal of sense because of the way that large order flows tend to work themselves through the forex markets. “Institutional orders tend to be placed in individual flows that come in succession,” according to recent forex market reports from iForex. “This generates changes in price that unfold in a successive fashion.” This should be encouraging for technical traders as well, because it gives more credence to the strategies that use chart activity as a basis for trading decisions. And when fractals are identified, traders are able to define the bandwidth of pip values that will make up the trend that follows.

 

In terms of trading tips, there are generally two approaches that can be taken when basing trading positions on fractal activity. Since fractals give us an idea of how far prices are likely to travel, we can use the fractal zones as support and resistance zones that create trade entries and profit targets. When uptrends are seen, trades can be established when prices move through the upper end of the fractal resistance zone. When downtrends are seen, trades can be established when prices move through the lower end of the fractal support zone.

 

Alternatively, trades can be taken using retest strategies. When uptrends are seen, long trades can be established when prices move to hit the upper end of the fractal resistance zone, fail to break it, and then fall back to the fractal support zone. When downtrends are seen, short trades can be established when prices move to hit the lower end of the fractal support zone, fail to break it, and then rise back to the fractal resistance zone.

 

As always, trading probabilities are enhanced when these signals are used in combination with other technical indicators. There are many different options available here. But since fractals are typically used to identify the strength or weakness in a trend, momentum indicators tend to be some of the most helpful tools when constructing trades.