Table of contents:
- 1 1)Trend systems
- 2 2)Cyclical systems
In the world of trade system development there are basically only two directions. Either the programmer builds a system based on trends or he focuses on cyclical movements.
In a trend system, the starting point is always the current trend. The trader measures and evaluates the trend pattern, and tries to determine entry and exit signals to match. For example, all breakout systems belong to this category. The trend therefore only functions as a filter.
Cyclical trading is ideal in times when there are no or few trends. Every cyclical trading system is about taking advantage of price swings. Oscillators are almost always used for this. You can easily recognize the system type when overbought or oversold market situations can be defined. For cyclical trading, the stochastic indicator is the prime example.
As a curious trader, the question may be allowed, if there is not something in between. So this would be an approach that works both in cyclical markets and in trend markets.
A “hybrid” would be trading with fractals. The term “fractal” is a creation of the chaos researcher Benoit Mandelbrot. He uses it to describe parts of a chaotic structure. This refers to course segments with similar shapes. A defined fractal can be found on all time levels, and can even be broken down again into partial segments. The principle is comparable to matryoshka dolls. This is a large wooden doll containing other smaller wooden dolls.
The Elliott Wave Theory works in the same way. Here, too, we find fractals that consist of defined course waves and can be broken down again into similar partial waves.
Alligator trading with fractals
Bill Williams was one of the first traders to consistently build a clear trading strategy based on fractals. For your information: Bill Williams should not be confused with the popular Larry Williams. Bill is a Trading-Vetetran (born 1932), who wrote two well-known trading books “Trading Chaos” and “New Trading Dimensions”.
Perhaps the most famous tool of his trading is the “Alligator System”.
The shape of the alligator head is a trend pattern
There is an upper and lower dotted line in the chart (see arrows). The dotted lines are created by fractals and visually form an alligator head (at least sometimes). In the Williams books the topic of chaos occupies a large area. For example, he puts forward the thesis that conventional indicators cannot work because markets are chaotic. Williams also fails to implement his thesis consistently. He himself uses a whole range of indicators. Even his alligator system contains moving average lines as a trend indicator.
However, the shape of the alligator head is very interesting. The shape of the head is an ideal pattern for trend markets. The skull shape is created by a strong price movement. It formed an impulse, whereby a second movement in the same one should occur. The mouth of the alligator is then a classic consolidation. The narrower the mouth is shaped, the more relaxed the market is. After that a new price dynamic in trend direction is created. The mouth opens again via the price dynamics.
Breakout trading with fractal patterns
The exciting thing about the alligator is its structure through fractals. They can be found in both cyclical and trendy markets.
The fractal is created by a counting pattern
Each fractal consists of five candlesticks. The dominant candlestick is always the third, because it forms the signal low or signal high. In a fractal down, candlestick no. 3 always forms the deepest low. In a Fractal-Down only the lows are important. Low 1 is deeper than the previous one. Low 2 is deeper than No. 1 and Low 3 is deeper than No. 2. Now comes the reversal: Low No. 4 is higher than Low No. 3 and Low 4 is higher than Low 5.
The reverse counting pattern is found in the Fractal-Up:
High 1 is higher than the previous candlestick.
High 2 is higher than High 1
High 3 is higher than high 2
High 4 is lower than high 3
High 5 is lower than high 4
A long signal is generated during the fractal up when the high of no. 3 is overbid. In contrast, there is a short signal in the fractal down when the low is undercut by no. 3.
In the alligator system, the down and up fractals are shown in a simple line shape. The five-count principle is always the basis.
Not every fractal is a good signal
You can universally integrate the fractal pattern into many trading systems. It would be a signal filter that increases the probability of success. It can be found without restriction in all liquid markets and even in every A-B-C formation.
However, if it appears so often, then one should not exaggerate its use. Otherwise the trading costs will increase too much. Backtests show that the unsystematic use of fractals is not effective. It seems obvious to use fractals in a trend, or more precisely, in trend direction. Incidentally, this is also what Bill Williams does with his alligator system. The chart in Figure 1 reveals it. Three moving averages are added to the alligator. They are MA5, MA8, and MA13 with an offset of eight candlesticks.
You can see how strong the effect is in a trend by looking at a simple filter. If you had traded the fractals with an MA40 as a trend filter and requested a closing price above MA40 for long trades and below MA40 for short trades, the following result would have been obtained for the DAX.
Trading results with underlying DAX on a weekly basis
Period: 01.01.1970 – 20.07.17
Hit rate: 54,3
Payoff ratio: 1.21
Profit factor: 1,44
Number of trades: 164
Max Drawdown: 29%
Each trade is terminated after 9 candlesticks (= 9 weeks).
The exit from trades
Most trading beginners are looking for a special trading approach. Therefore they are looking for ideal entry formations. Most of the time the original idea is still linked with many additional conditions. 80% of the development time is used for the optimal entry. The remaining 20% for the exit. This is a technical error, because the entry and exit are linked in terms of content. For example, if you implement an entry in a trend, but then use an oscillator for the exit, you will limit your average profits. It is in the nature of an oscillator that it reverses in its limit range. This could take a good trade out of the market even though the trend is still going on.
In system development, entry and exit are equal. Accordingly, the same amount of time should be used for optimization.