Fractal Indicator: Definition, What It Signals, and How To Trade With It

What Is a Fractal?

The fractal indicator identifies potential trend reversals by spotting recurring patterns across different time scales. Suppose you're using a map app to zoom in on a coastline map. As you do, the jagged edges maintain a similar shape, whether you're looking at miles of shoreline or just a few feet. This self-similarity at different scales is the essence of fractals, and it's this concept that the indicator applies to financial markets.

The fractal indicator doesn't rely on complex mathematical formulas. Instead, it identifies specific price patterns that occur naturally in markets. When correctly interpreted, these can signal potential turning points in trends, offering traders prospects for both entries and exits. The bullish fractal pattern signals the price could move higher. A bearish fractal signals the price could move lower. A down arrow marks bullish fractals, and an up arrow signals bearish fractals.

Below, we'll explore how the fractal indicator works, what its signals mean for traders, and practical strategies for incorporating it into your trading.

The Formulas for Fractals:

$\begin{aligned} \text{Bearish Fractal} =\ &\text{High} ( N ) > \text{High} ( N - 2 ) \text{ and} \\ &\text{High} ( N ) > \text{High} ( N - 1 ) \text{ and} \\ &\text{High} ( N ) > \text{High} ( N + 1 ) \text{ and} \\ &\text{High} ( N ) > \text{High} ( N + 2 ) \\ \end{aligned}$Bearish Fractal= ​High(N)>High(N−2) andHigh(N)>High(N−1) andHigh(N)>High(N+1) andHigh(N)>High(N+2)​

$\begin{aligned} \text{Bullish Fractal} =\ &\text{Low} ( N ) < \text{Low} ( N - 2 ) \text{ and} \\ &\text{Low} ( N ) < \text{Low} ( N - 1 ) \text{ and} \\ &\text{Low} ( N ) < \text{Low} ( N + 1 ) \text{ and} \\ &\text{Low} ( N ) < \text{Low} ( N + 2 ) \\ \end{aligned}$Bullish Fractal= ​Low(N)<Low(N−2) andLow(N)<Low(N−1) andLow(N)<Low(N+1) andLow(N)<Low(N+2)​

$\begin{aligned} &\textbf{where:}\\ &N = \text{High/low of the current price bar} \\ &N - 2 = \text{High/low of price bar two periods} \\ &\text{to the left of }N \\ &N - 1 = \text{High/low of price bar one period} \\ &\text{to the left of }N \\ &N + 1 = \text{High/low of price bar one period} \\ &\text{to the right of }N \\ &N + 2 = \text{High/low of price bar two periods} \\ &\text{to the right of }N \\ \end{aligned}$​where:N=High/low of the current price barN−2=High/low of price bar two periodsto the left of NN−1=High/low of price bar one periodto the left of NN+1=High/low of price bar one periodto the right of NN+2=High/low of price bar two periodsto the right of N​

How To Calculate the Fractal Indicator

Calculating fractals has more to do with visual acuity than math.

1. Isolate a high/low (N) point on the chart.
2. If there are two lower highs to the left of the high or two higher lows to the left of the low (N-2 and N-1), there is a possible pattern. The pattern still needs two more bars on the right to be confirmed.
3. If two lower highs occur after the high then a bearish fractal is complete (N+1 and N+2). If two higher lows occur after the low, a bullish fractal is complete.

What the Fractal Indicator Tells You

The existence of a fractal isn't necessarily important since the pattern is quite common. Rather, the fractal means the possibility of a trend change. This is because fractals are essentially showing a "U-shape" in price.

A bearish fractal has the price moving upward and then downward, forming an upside-down U. A bullish fractal occurs when the price is moving down but then starts to move up, forming a U.

Because fractals occur frequently and many signals aren't reliable entry points, fractals are typically filtered using other forms of technical analysis. The inventor of the indicator, Bill Williams, also invented the alligator indicator, which isolates trends. By combining fractals with trend analysis, a trader may only trade bullish fractal signals while the price trend is up. They might only take short trades on bearish fractal signals if the trend is down.

Fractals could also be used with other indicators, such as pivot points or Fibonacci retracement levels. You would only act on a fractal if it aligns with one of these other indicators and potentially the longer-term price direction.

For example, suppose a stock is trending higher. The price is pulling back and reaches a 50% Fibonacci retracement level. Since the trend is up and the price is near a Fibonacci retracement level, the trader will take a trade if a bullish fractal forms.

The Difference Between the Fractal Indicator and Chart Patterns

The fractal indicator is unique in that it identifies a price pattern and marks it on the chart. Fractals are specific five-bar patterns. Chart patterns can also be drawn on the chart, although they are not limited to five price bars. Below are some of the most popular chart patterns:

Limitations of Using the Fractal Indicator

The main problem with fractals is that there are so many of them. Trying to trade would end up in a lot of losing trades, called false signals or whipsaws. Therefore, you'll need to filter the signals with some other indicator or form of analysis.

The arrows for the indicator are typically drawn over the high or low point, which is the middle of the fractal, not where the fractal completes. As such, the arrows can be visually deceiving. Since the pattern completes two bars to the right of the arrow, the first available entry point after seeing an arrow is the opening price of the third bar to the right.

The Bottom Line

The fractal indicator offers traders a unique way to identify potential trend reversals by spotting recurring patterns in price action. While it's not a stand-alone solution for predicting the market, fractals can provide greater clarity about potential turning points when used with other technical tools and fundamental analysis.

As with any trading tool, proper understanding and practice are key to effectively incorporating fractal analysis into your trading strategy. Remember, no indicator is infallible, and risk management should always be a priority in your trading decisions.