Fractal Indicator Strategy — What Is It? (Backtest)
Last Updated on April 18, 2023
The financial markets may seem to move randomly, but they actually move in repeating patterns and trends. One indicator traders use to take advantage of the patterns is the fractal indicator. What is it?
Fractal is the simplest form of the repeating patterns that form in the financial markets. The fractal indicator is a simple five-bar reversal pattern that isolates potential turning points on the price chart and marks them with arrows. It helps traders determine the direction price will develop, so it may be used to identify trading opportunities or when to exit a trade.
A fractal indicator strategy is not easy to backtest, but at the end of the article, we present you with such a strategy.
In this post, we take a look at the fractal indicator and how to use them.
What is the fractal indicator?
Fractal is the simplest form of recurring patterns in the financial market. The fractal indicator identifies these patterns and isolates potential reversals on the price chart. It draws arrows to show the presence of these patterns.
The fractal signals can be bullish or bearish, based on the reversal it is indicating. The bullish fractal tells you that the price has the potential to move higher and is marked by an arrow below it (light-blue arrows in the chart below). On the other hand, a bearish fractal tells you that the price has the potential to slip lower and is marked by an arrow above it (the light-red arrows in the chart below).
A bullish fractal is formed when there is a low bar with two higher bars on each side of it. Conversely, a bearish candle is formed when there is a high bar with two lower bars on each side of it. An up-arrow (above the price) usually indicates a bearish fractal while a down arrow (below the price) indicates a bullish fractal.
The arrows are drawn in the mid-bar (low or high bar), in as much as the pattern consists of five bars, there is no possibility that you can place a trade at the up arrow because the arrow will only be formed after the price action has made two new bars. The entry signal would usually be the opening price of the third bar after the arrow. Thus, the fractal indicator is a lagging indicator.
Fractal indicator formula
The formulas for calculating the fractal indicator are as follows:
Bullish Fractal = Low Price (n) < Low Price (n – 2) and
Low Price (n) < Low Price (n – 1) and
Low Price (n) < Low Price (n + 1) and
Low Price (n) < Low Price (n + 2),
Bearish Fractal = High Price (n) > High Price (n – 2) and
High Price (n) > High Price (n -1) and
High Price (n) > High Price (n + 1) and
High Price (n) > High Price (n + 2).
n = the high and low of the current price bar.
n – 2 = the high and low of the price bar two periods before n.
n – 1 = the high and low of the price bar two periods after n.
n + 2 = the high and low of the price bar two periods before n.
n + 1 = the high and low of the price bar two periods after n.
To identify fractals manually on the chart:
Isolate a high or low point on the chart.
If a high has lower highs to the left and right, then a pattern has been formed. The pattern needs two additional bars to the right of it as confirmation if you are using the default 5-bar setting.
If a low has a higher low on both sides of it, then a pattern has been formed. However, the pattern needs two additional bars to the right for confirmation.
How is the fractal indicator used in trading?
The fractal indicator is available on the most popular trading platforms. This means that you don’t have to identify the patterns yourself since the indicator will do this for you. However, there is chaos everywhere on the chart as the bars are littered with patterns.
Fractals are best employed when used together with other indicators or another form of analysis. Some of the most used indicators with fractal is the Williams’ alligator, a tool created by using multiple moving averages.
While the signals might be confusing, a bullish fractal is drawn with a down arrow below the price and a bearish fractal is drawn with an up arrow above the price. If you are using the fractal indicator in a downtrend, look for bearish fractals (up arrows above the price) after price rallies. And if using the fractal indicator in an uptrend, look for a bullish (a down arrow below the price) after a pullback.
This strategy can provide you with a lot of trading opportunities, but it is left to you to control risk. Switching from a lower timeframe can be helpful as the signals generated will be clearer to spot entries in the market.
As mentioned before now, fractals are not drawn until the price has already moved past two bars. So, in an uptrend, stop loss could be placed anywhere below a recent low or the previous bar low. In the same fashion, stop loss could be placed above a recent high or the previous bar high in a downtrend. Fractals can be used to exit trades. For instance, when you are on a long trade, the next signal is given when you spot a bearish fractal.
What is William’s fractals indicator?
The fractal indicator was developed by the renowned trader Bill Williams. As a result, it is also referred to as the Williams Fractal Indicator.
Williams first presented the fractal indicator in his book, “Trading Chaos.” According to him, the idea for the indicator traces its origins to mathematical chaos theory, where fractals are described as any kind of recurring pattern.
What are the best settings for the fractal indicator?
In most trading platforms, the default setting for the fractal indicator is five periods or bars — of course, a period is a trading session, which is represented by a price bar/candlestick. However, it doesn’t mean that the 5-bar setting is the best for every asset or market. Even in the same market, volatility and other market conditions vary from time to time. So, the only way to know the best setting for the fractal indicator for the market you are trading is to back-test and even forward-test on a demo account.
Fractal indicator strategy (backtest)
The trading rules are pretty simple.
Generally speaking, a bullish fractal happens when there are two higher low bars on each side of a candlestick or price bar. A bearish fractal happens when there are two lower highs on each side.
Below is an example of a bullish fractal (up fractal):
Opposite, this is a bearish fractal:
With this in mind, we can pretty easily set up a potential trading strategy we can backtest (on S&P 500 – SPY).
Let’s first look at a bullish fractal. We enter at the close of the signal and we exit after N-days (from 1 to 10 days).
The first column shows the number of days we hold the position and the rest of the columns show the statistics and historical performance. Column 4 shows the profit factor and as you can see that one is not very impressive.
Does it get any better when we “flip” the strategy? Let’s backtest the bearish fractal indicator:
We would argue the strategy performs more or less the same no matter bullish or bearish fractal. We also backtested many other assets like bonds, gold, QQQ, etc, but with more or less the same (poor) results.
List of trading strategies
You can get the code for the fractal indicator strategy together with plenty of other different strategies.
We have written over 800 articles on this blog since we started in 2012. Many articles contain specific trading rules that can be backtested for profitability and performance metrics.
The trading rules are compiled into a package where you can purchase all of them (recommended) or just a few of your choice. We have hundreds of trading ideas in the compilation.
The strategies are taken from our list of different trading strategies. The strategies are an excellent resource to help you get some trading ideas.
The strategies also come with logic in plain English (plain English is for Python traders).
For a list of the strategies we have made please click on the green banner:
These strategies must not be misunderstood for the premium strategies that we charge a fee for:
Fractal indicator strategy – conclusion
The fractal indicator strategy is quite popular among traders (like Gann, Elliot Wave, etc.), yet just a tiny few traders have backtested it. In this article, we made trading rules in an attempt to make a backtest of the strategy. The result is somewhat promising for the gold price (GLD) and we are confident it can be improved by adding another parameter.