Fractal Trading Strategy - Learn How That Works

Fractal Trading is a popular method of identifying reversals on the price chart. Forex traders should have noticed that prices do not reverse suddenly. In most cases, the chart draws a U-shaped formation when the downtrend is getting exhausted and the bulls take the market under control. In case of a bearish reversal, the shape of the chart is usually similar but mirrored. Therefore, technical analysts noticed that price charts have certain geometric pictures or patterns that repeat from time to time. The fractal is one of them.

In simple words, a fractal occurs when two left candlesticks rise, one middle candlestick continues the previous trend with a higher high, and two right bars are descending. This type of drawing is related to a bearish reversal when the market is peaked at some point. For a bullish reversal, the opposite formation appears on the chart. What matters in the fractal pattern is highs (bearish) and lows (bullish), while open and close rates are ignored.

The direction of the centre candle does not matter as the pattern takes into account five bars in total.

What is a fractal in trading


This trading method is based on a fractal indicator. This sequence was noticed by Bill Williams, the same technical analyst who invented Williams %R oscillator and alligator indicator. This is why fractals are also called Williams Fractal.

The indicator has only arrows on the price chart. They appear after the conditions of the formation are met. It’s worth noting that arrows are shown on the price chart at the centre candlestick and they are formed only after the second candle after it is formed. Therefore, the indicator has a bit lagging nature and the trading signal occurs only after all five candles finalize the pattern.

How does fractal indicator look like?


An example of the fractal indicator in action is shown on the daily chart of EUR/USD below. Those arrows that are above the price point to a bearish reversal, while bottom arrows are bullish.

Fractal Trading Strategy - Learn How That Works

The trading technique is a reversal strategy meaning that traders open long positions when the price was moving lower and fractal indicator signalled a bullish reversal. If the trend was moving north and the fractal signal occurred, traders open short positions.

The reversal trading strategy evolves certain risks as traders are keen on going against the recent trend. This is why stop-loss orders have to have a longer distance in pips than acting following strategies based on following trends. As long as the pattern is quite common, fractals provide rather frequent entry opportunities with a large number of trading signals.

How to trade with Forex fractals?


Fractals Forex have five candlesticks to complete the signal. Thus, after getting a reversal signal, traders open positions on the sixth candlestick open. If the arrow appears below the price, then traders should consider opening long positions. Otherwise, short deals are preferred.

Best time frames for fractal Forex trading


The fractal indicator works with any timeframe and any asset. Thus, traders should choose chart periods under their individual trading strategies.

As far as the reversal strategy is riskier than a with-the-trend method, it’s worth considering the main trend’s direction and monitors larger timeframes for the analysis. There is a method which suggests opening only longs if the overall trend is headed north and ignore bearish fractals, for example.

Stop-loss orders


Stop-loss orders should be set below the low of the centre candlestick where the fractal appeared. At the same time, traders should keep in mind the general rules of setting stop-loss orders and maintain an effective level of the profit/loss ratio. Another factor to consider when opening positions with fractals forex trading is the reasonable target compared to a possible stop-loss. So, for instance, if the current trend has a potential of growth at around 50 pips before a strong resistance level, while the reasonable stop-loss order should be set for 80 pips, then such a deal is not attractive, and traders should ignore the fractal signal.

Take profits


Targets should be identified depending on the overall trend’s direction. If the long-term development suggests the upwards direction then it’s worth expecting a large potential of further growth. So, when the rate bounced down and formed a bullish fractal, then the take-profit order should be set for a larger distance in pips. On the other hand, if a trader is looking to open a counter-trend position with a bearish fractal formed on the price chart, then the take-profit order should be tighter. Nonetheless, money management rules apply.

If you like this strategy, you might also be interested in this London Breakout Strategy

Fractal Indicator formula


Fractal forex application is simple and reliable. The pattern could be easily recognized at first sight without any indicator. Therefore, it’s more about visual analysis then math. However, before using fractals on real-money accounts, traders and analysts should know how it works in terms of the formula.

Bearish Fractal occurs when all four conditions below are met simultaneously:

  • High (N) > High (N-2);
  • High (N) > High (N-1);
  • High (N) > High (N+1);
  • High (N) > High (N+2).

The list of conditions for the bullish fractal will look as follows:

  • Low (N) < High (N-2);
  • Low (N) < High (N-1);
  • Low (N) < High (N+1);
  • Low (N) < High (N+2).

Where:

  • N is High/Low of the middle (current) candlestick;
  • N-2 is High/Low of the candle two periods to the left of N;
  • N-1 is High/Low of the price bar one period to the left of N;
  • N+1 is High/Low of the candle one period to the right of N;
  • N+2 is High/Low of the price bar two period to the right of N.

Using other technical indicators with fractals


Like any other trading strategy based on the technical analysis, fractal energy trading needs a multi-level confirmation. Fractal trading system really works more effectively in combinations. Before choosing the best secondary tool to supplement fractals, traders should know about their weak points.

Limitations of fractal trading


Most of the trading signals are lagging as two candles are required after the centre one to complete the formation. Therefore, trading signals appear with a delay, and they are shown on the middle candle, which certainly had a more attractive entry point. So when looking back at the price history on the chart, traders could have a deceiving impression about the Williams Fractal Indicator effectiveness.

What is the difference between fractals and chart patterns?


Traditional chart patterns like triangles, flags or head-and-shoulder could have an unlimited number of candlesticks. Fractals are always based on five bars. This is why the application of the method could be limited. Another concern is that fractal arrows are marked on the chart automatically, while most of the chart patterns are drawn by the hand of a chartist.

Choosing the best technical indicator to use with fractals


A wide variety of instruments can be used for that purpose. Choosing the best one depends on an individual trading strategy and the exact scenario of the price action. For example, during a strong trend, the depth of a possible rebound has to be calculated accurately. Fibonacci Retracement Levels, Ichimoku Cloud indicator, Moving averages and pivot points will help to do so. On the other hand, when trading in both directions, sensitive oscillators such as Stochastic RSI and alligator will be useful. Below are several examples of profitable trading decisions.

Fractal with Ichimoku


USD/JPY was in the strong uptrend, according to the hourly chart below. After bouncing back down to the support level, which was underlined by Ichimoku Base Line, a fractal buy-signal occurred. The leading span was bullish, all lines were in the right order to proceed with the uptrend, so the Ichimoku Cloud trend indicator confirmed the signal and the long position was opened. The profit was taken after an opposite (bearish) fractal appeared above the rate.

Fractal Trading Strategy - Learn How That Works

Fractal, Stochastic RSI and True Strength Indicator


USD/CHF was in a sideways consolidation on the hourly chart below. The True Strength Indicator signalled the start of the downtrend as its both lines dropped below zero. That signal was confirmed by Stochastic RSI, the lines of which performed a bearish crossover. Therefore, both indicators confirmed the bearish fractal and the short position was opened two candles after it. Several bullish fractals were ignored after that as they were not confirmed by technical indicators. The profit was taken only when TSI’s lines crossed each other and headed North, confirming the bullish fractal.

Fractal Trading Strategy - Learn How That Works

Conclusion


Fractal Trading is a simple and reliable method of finding reversal points. The pattern appears quite often on the price chart, so the number of trading signals is large. However, some of them do not give enough depth for the price action and limit potential profit. What’s more, Williams Fractal is lagging indicator consisting of five candlesticks. Therefore, additional technical indicators could play a useful role in the trading strategy, confirming signals and filtering unnecessary noise. Like in any other type of trading approach, forex traders should keep in mind general strategy and money management rules.
See also: