What are fractals and how can they help in stock trading?

Why does the market sometimes seem to repeat itself? Why do certain price patterns keep recurring – whether we look at a minute, daily or weekly chart? The answer to these questions may lie in one of the most intriguing phenomena in technical analysis – fractals.

In the world of investing, where many market participants try to predict the future based on past data, fractals are becoming a tool that combines mathematical theory with practice. They are not a magic bullet, but they can point to places where history begins to “rhyme” with the present. This is where turning points, resistance levels and key moments for investment decisions may lie.

In this article, you will learn what fractals actually are in the context of the market, how they work, how to interpret them and how to use them to make more accurate decisions in the market.

What are fractals in trading?

Fractals is a concept derived from mathematics and fractal geometry, describing self-similar objects. This means that the fragments of such an object have a shape similar to the whole. There are many examples of fractal structures in nature (e.g. the coastlines of continents or the shape of leaves). The term was popularized by the mathematician Benoît Mandelbrot, who showed that fractal patterns occur in many natural and non-natural phenomena.

Fractal in Latin means "broken" and/ or "partial", which reflects the fragmentary structure of such structures. A characteristic feature of fractals is the fractal dimension, which determines their mathematical complexity. In modern science, examples of fractal objects include the Sierpinski triangle, the Koch curve, or the Mandelbrot set, as well as the aforementioned plant branching, organ structures, or the shape of coastlines.

Research suggests that financial markets can also exhibit fractal properties – observed price patterns often repeat themselves on different time scales. Mandelbrot suggested that repeating price patterns reflect investor cycles and can help predict market turning points.

Technical Analysis and Fractals

In technical analysis the word "fractal" refers primarily to the indicator developed by Bill Williams. In his book "Trading Chaos” describes the principles of detecting turning points by observing repeating patterns of five consecutive candles. The “Williams Fractal” indicator is one of the first popular tools based on this concept. It usually consists of five candles on a price chart, and the local maximum or minimum (middle candle) is marked with an up or down arrow. The indicator is therefore used to automatically identify small peaks and troughs on the chart that may herald a change in the direction of price movement.

Typical fractal formation therefore, it includes five consecutive price bars. In the case of a bearish pattern (suggesting a possible end to the uptrend), the middle candle is the highest, surrounded by two lower ones on either side. In the opposite, bullish pattern, the middle candle is the lowest, and on the sides there are candles with higher lows. Such a price arrangement resembles the letter "A" (for a bearish pattern) or "V" (for a bullish pattern).

On the chart, this formation can be seen only after the formation of two more candles, which makes the fractal indicator relatively delayed. However, once we recognize such a pattern, we get an indication of a potential turning point, which can be extremely useful for some investors and investment strategies.

In practice, fractals are mainly used as indicators of turning points and breakouts of important price levels. Generally, when the price breaks through the extreme set by the previous upper fractal, it is considered a signal to continue the uptrend. Similarly, a breakout below the level of the lower fractal is considered a signal for a downtrend. In other words, if the next candle closes above the last local high or below the last low, it may indicate a breakout of the previous trend and the beginning of a new price impulse.

Bullish fractal patterns indicate local resistance levels, while bearish ones indicate support levels, which helps in determining safe entry or exit points. Some traders draw horizontal lines through the last fractals, treating them as key price barriers. In addition, many traders place pending stop orders near fractal levels, for example a few points above the previous high of a bullish fractal or below the low of a bearish fractal, to automatically open a position in the event of a breakout.

It is worth remembering, however, that fractals are lagging indicators and their formation is confirmed only after the formation of subsequent candles on the chart. This means that the signal itself appears with a delay. In practice, it is therefore recommended to use fractals as confirmation of signals coming from from other technical analysis tools (e.g. oscillators, moving averages or market structure changes).

Fractals work best as part of a broader strategy.

In turn, in a strongly horizontal market, there can be many (false) fractal signals, which is why it is important to consider the market context when making decisions. Additionally, Mandelbrot himself warned that fractal formations do not guarantee specific price changes, but only indicate repeatability of structures. This means that they do not accurately predict the reversal date, but only increase the likelihood of certain movements occurring.

It is also worth mentioning Edgar Peters' fractal market hypothesis, according to which stock market prices may have a fractal structure and these patterns may repeat themselves different time scales. A practical application of this theory is to use the detected fractals to determine support/resistance levels and planning entry and exit from positions after signal confirmation on different time intervals (for example, with a potential top on the weekly chart, it may be worth taking a short position on a smaller time frame, at the point where the situation there also starts to become more bearish).

Fractal logic can be applied to many markets. It works on the stock market, the Forex market, and the cryptocurrency market. This means that searching for analogous patterns in the history of quotes of a given instrument can be used regardless of the market.

How to detect fractals in stock trading?

Investors use various tools to visualize fractals. One of the most popular is the platform TradingView, which provides a built-in indicator "Williams Fractal". When added to a chart, TradingView automatically marks the locations of fractals with arrows according to the five-candle rule. As a result, arrows pointing up (signaling local peaks) or down (indicating local troughs) appear on the chart. By default, the indicator uses five candles, but you can change this number in the settings, adjusting the formation to your own preferences.

Bill Williams' tools are also available on popular platforms MetaTrader 4 i MetaTrader 5 in the bookmark Pointers -> Bill Williams Pointers. 

In addition to the built-in tool, TradingView also provides scripts written in Pine Script, which automate the detection of fractals or related support/resistance levels. This allows traders to easily experiment with different variants of fractal analysis on any instruments and time frames.

Summary

Fractals in technical analysis is a concept based on the idea of ​​repeating price patterns and potential turning points. The fractal indicator helps traders visually mark local highs and lows on charts and signal potential trend breaks.

The best results are achieved when treated as an auxiliary tool – it is crucial to combine fractal signals with confirmations from other market analysis methods, which improves the reliability of the signals. This is because fractal signals, by their nature, are delayed in relation to market events. Therefore, relying on fractal formations alone is rarely enough to make investment decisions. Treating them as guidelines, and not a single recipe for success, can allow you to effectively use their advantages in trading.