What is a Fractal
A fractal is a recurring geometric pattern that is repeated at ever smaller scales to produce irregular shapes. Not surprisingly, these patterns can be found in the securities markets where prices and trends tend to repeat themselves.
BREAKING DOWN Fractal
The most popular fractal used in technical analysis is the Bill Williams' Fractal, which is formed around a group of five consecutive bars. The first two bars are successively moving higher and the last two are descending lower. The middle bar is the highest (or lowest) in the group. Bearish reversals are indicated by an upward pointing arrow, while bullish reversals are indicated by a downward pointing arrow.
It's important to note that the Bill Williams' Fractal and other fractal-based indicators are lagging indicators. Bullish and bearish reversals aren't identified until two bars after the signal bar since the fractal pattern must be completed in order to be validated. As a result, these indicators tend to perform best in trending markets where there is less volatility that can lead to whipsaw behavior.
The Bill Williams' Fractal generates a lot of signals since the five bar pattern is commonplace. Often times, traders use the fractal indicator in conjunction with the Alligator Indicator to produce more reliable trading signals. The Alligator Indicator - also developed by Bill Williams - combines moving averages with fractal geometry to produce a more robust trading system.
Fractal signals can also be combined with other technical indicators, such as Fibonacci retracement or various moving averages. In other cases, traders may use the indicator alongside chart patterns as a confirmation of a change in trend.
Finally, it should be noted that this is not a widely used indicator, so it may not be available for every type of charting application. But various third-parties have developed plug-ins which make using fractals possible.
Example of a Fractal Pattern
The following chart shows an example of a Bill Williams' Fractal applied to the SPDR S&P 500 ETF (NYSE ARCA: SPY).
In this example, you can see that the Bill Williams' Fractal produces many different readings. These readings may appear to be uncannily accurate, but it's important to note that there is a two-bar lag in practice. This means that traders wouldn't be able to enter a trade until two bars after the trading signal was issued. That's why it's important to combine the indicator with other forms of technical analysis to maximize the odds of success.