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Fractal Finance

Fractal Finance: Is there an alternative to the mathematical orthodoxy ofonline stock trading the financial markets? 

Yes! - and it's called fractal finance.

Given recent and ongoing turbulence, and the extent to which the so called professionals have underestimated market risk the time may have come to consider the fractal finance approach for your online stock trading.  So what is fractal finance - let's have a look at some of the basics.

Fractal Finance - Introduction

This page is purely an introduction to the subject as I am currently developing a separate and dedicated website to cover this topic in more detail. The great Warren Buffet has stated that we may be facing years of turbulence because of the over use and over reliance of derivatives and the danger they pose when there is a sudden sell off by "electronic herd". 

Such a sell off is happening now in the mid 2007.  What is even more worrying is that the automated mathematical models used to trade these products are all based on the principle of standard deviation (the bell curve) with the focus on averages.  They discount the levels of volatility which actually make up large parts of the market.  A recent senior bank executive admitted on national television that the problems with one of their funds, based on sub-prime mortgages developed because they had not factored into the model the possibility that houses could actually FALL!  Astonishing!!! It is this ongoing "chaos" which had led me to look again at the use of fractals in trading and investing, and chaos theory as a whole.

Fractal Finance : Chaos Theory & Fractals

The butterfly effect first described in 1972 "Does the flap of a butterfly's wings in Brazil set off a tornado in Texas" is probably how most people understand chaos theory.  To summarize this quote: a small, seemingly random event in the markets creates an overwhelming and disproportionate reaction.  In mathematics and physics it describes the behaviour of non linear, dynamic systems such as weather patterns, earthquakes and the financial markets.  Although these systems often appear to be random they are in fact a higher form of order. Fractals in essence are any pattern that reveals greater complexity as it is enlarged. Thus, fractals graphically portray the notion of 'worlds within worlds' which has obsessed Western culture from its tenth-century beginnings.

Fractal Finance : Non Linear Markets

Because markets are a construct of the humans and their social systems, the actions of the markets are therefore shaped by subjective ideas that form in the human brain.  If markets are formed by the combined interpretations of this human brain, it is reasonable to deduce that the markets will in turn act in a non linear, random fashion. If, as traders and investors, we accept this explanation it follows that trying to apply conventional linear tools and indictors to this chaotic and random world is doomed to fail.  This is one of the reasons why there are so many technical indicators, as each work for a time before ultimately failing.

For a system to be considered "chaotic" it must have a fractal dimension.  This term was first coined by the famous mathematician Benoit Mandelbrot. A fractal is an object in which the individual parts are similar to the whole.  Fractals are self similar.  A cauliflower is a perfect example where each element is a perfect recreation of the whole, a snowflake is another.

How is the stock market associated with a fractal?  Easily, if one looks at the market price action taking place on the monthly, weekly, daily and intra day charts where you will see the structure has a similar appearance.  Followers of this approach have determined that market prices are highly random but with a trend.  They claim that stock market success will happen only by following the trend.  A system can be random in the short term but deterministic in the long run.  The saying, "Let the trend be your friend" comes to mind. Trading on intra day charts such as 5 and 10 minutes can be likened to trading on 'noise', and an approach which is doomed to fail given the associated costs of trading. Traders can succeed as long as they trade longer timescales of weekly and monthly charts and follow the underlying trend. This naturally raises the question of how short term data can be random, whilst longer term data is not - is this a paradox. The new site will cover this aspect in more detail, and will show that this apparent paradox can exist.

One other important aspect of this theory relates to volatility.  Mandelbrot has always maintained that the financial markets are much volatile and therefore riskier and more dangerous than the industry will admit to.  His article in Fortune magazine of July 11th 2005 explains this in more detail and given these uncertain times has never seemed more relevant. The article is entitled " How the Finance Gurus get Risk All Wrong"

The above barely skims the surface of this approach to trading, and I am currently developing a site which will cover the whole subject of fractal finance in great detail. In addition it will also include an online trading system which will allow you to apply these techniques and to test the theory in practice. Theory is all very well, but if we cannot apply it in practice it is simply an intellectual exercise.

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