Fractals help a lot in identifying the underlying fluctuations in the price waves. Fractals are used in breaking the larger trend in the market into much simpler and predictable reversal patterns. If you have been trading forex for a while, you must have come across the term Fractals a lot. Many EA developers will tell you that their expert advisor uses fractals in its algorithm. So what makes these fractals so important for forex traders or for that matter any trader and what is their background.
Fractals were first introduced by Bill M. Williams in his book, Trading Chaos. Trading Chaos in fact is considered to be a groundbreaking book for traders as it for the first time talked about Chaos in the markets as a form of higher order as compared to disorder that we normally associate it with. Chaos is considered to be the random disorder in any system. But Bill for the first time talked about Chaos as something good and natural for the market.
What Bill wrote in his book went against the conventional
maquillaje analysis theory. Conventional Technical Analysis Theory says that past prices can be used to confirm future prices. But Bill in his book maintained that past prices have no relevance to the future prices and cannot be used in the prediction of the future prices. According to Bill price action is purely random with no link between the past prices and the present prices.
His book contains all the discussion. You should read the book because many automated trading systems or EAs claim to have been based on this chaos theory and the fractals as explained by Bill in his book, Trading Chaos.
Let's get down to the basics of Fractals as this is a very important concept in forex trading and many trading systems use fractals extensively. Fractal Patterns on a bar chart consists of at least five consecutive bars. An initiating Fractal is defined as that middle bar that has higher highs or lower lows than the two preceding bars and the two following bars. Now, once the fractal pattern is initiated, it can be either a Bullish Probable Reversal Pattern or a Bearish Probable Reversal Pattern.
A Bullish Probable Reversal Pattern will have the lowest low in the middle and two higher lows on either side. Whereas a Bearish Probable Reversal Pattern will have highest high in the middle and the two lower highs on either side. So, a fractal pattern comprises five bars and can be of two types.
These fractal patterns are used in catching the trend in the market. You can identify the type of the trend depending on the series of fractals that are successively broken. More up fractals will be broken in an uptrend and more down fractals will be broken in a downtrend. The more the fractals are broken, the more stronger will be the trend.