Detecting patterns in price movements - Fractals for beginners
At a glance, price movements on the market seem random and chaotic. They move in a way that cannot be predicted. However, upon close inspection, one can still detect some patterns in those movements that regularly repeat; one can see that on many occasions, price increases are followed by price drops and vice versa and that they have some sort of recurring pattern.
There are many indicators in
Forex trading platforms that enable traders to discover those patterns. One such indicator is called fractal and while it may seem like a complex mathematical formula, it actually refers to a repeating pattern that occurs in a chaotic world of price fluctuations.
The pattern itself consists of five candles charted in a candlestick chart. The commonality between the different types of fractal indicators is that the price pattern looks like an arrow: at some point, the price is increasing, then it reaches its peak and starts to decline; on the flip side, the price is decreasing, then it reaches its peak and starts to increase. By observing these movements, traders can get the idea of when it is best to buy or sell a security.
Based on the previous description of patterns, we can outline two main fractal patterns in trading:
- Up fractal (bearish)
- Down fractal (bullish)
The up fractal, also known as the bearish fractal, occurs when the price has been increasing up until some point, then it reached its highest point and finally started to decrease. In a five-candle pattern plotted in a candlestick chart, this pattern can be identified as follows: the middle candle (a turning/reversing point) marks the highest high price in the chart, whereas the two hands on the left and on the right mark lower high prices.
The down fractal, also known as the bullish fractal, occurs when the price has been decreasing up until some point, then it reached the lowest price and started to increase once again. The down fractal indicator in the trading chart looks like this: the middle candle of the bullish fractal marks the lowest low price, whereas the two hands on the left and on the right mark the higher low prices.
The up and down fractals can be categorized in yet another way. When the outer hands of the pattern are symmetrical to each other, then the fractal is perfect; and when the outer hands don’t align against each other, the fractal is imperfect.
How to use fractals in trading?
Fractals have become incremental to trading, therefore, almost all of the popular trading platforms (MetaTrader 4/5, cTrader, etc.) are offering this indicator without additional installations. In order to toggle the fractals indicator MT4, the user has to go to the Insert menu at the top-right corner, go to the Indicators list, come down to Bill Williams, and select Fractals.
Then, the indicator will be added to the selected chart and it will mark all the up/down patterns on it. As for the customizability, traders can choose the color of the arrows, as well as the timeframe.
To use an up or down fractal in trading, there is one essential requirement to it: the fifth candle has to close in order for a pattern to be recognized as a fractal. Otherwise, a signal received from the indicator will not be accurate. That’s because, before closing, the fifth candle can take a completely opposite direction and make the fractal disappear from the chart.
Broken fractals
Once all the candles in a fractal are closed, then traders can use the indicator to make decisions. One way of using fractals in Forex, or any other market, is to look for broken fractals. A broken fractal is a pattern that has been confirmed but the next (sixth) candle went higher/lower than the highest/lowest point of the fractal.
For example, an up fractal can be considered broken if the next candle immediately after the fractal goes higher than the highest point of the fractal. This pattern suggests that the market is increasing (bullish) and therefore, it can be a good idea to buy an asset (go long).
Conversely, a down fractal can be considered broken if the next candle following the fractal goes lower than the lowest point of the fractal. This suggests that the market is declining (bearish) and it can be a good idea to sell an asset (go short).
Coupling with other indicators
When using fractals in actual trading, traders tend to notice one thing: fractals occur quite often in the chart. Therefore, they may not be the most accurate indicators on their own. That is why traders tend to use it in conjunction with other indicators.
One of the most popular technical indicators used alongside the fractal indicator is the alligator. The alligator is a trend confirmation indicator that consists of three moving averages. The three average trends can describe the trend movement more accurately and indicate whether it is going up or down.
Then, traders can use fractals to place a stop loss at a certain price point. For instance, during an uptrend, a trader can place a stop loss at the most recent low of the down fractal. This way, they will continue their long (buy) position as long as the price stays above the stop loss point.
For a downtrend, a trader can place a stop loss at the most recent high of the up fractal. This way, they will continue their short (sell) position as long as the price stays below the stop loss point. One additional step traders take to make this combination more accurate is to choose longer timeframes. By doing this, they reduce the number of fractals and make it easier to detect trading opportunities.