Welcome to

The Fractal's Edge Stock Trading Method

The cutting-edge trading system that allows you to peer into the
underlying and profitable order beyond the chaos of the stock market.

[Link]

IMPORTANT NOTICE

This is not a get-rich-quick scheme. Effort is required to learn the system. Just as the potential for profit exists
in trading stocks, so does the risk of loss. Past performance is not necessarily indicative of future results.
Trading stocks has large potential rewards, but also large potential risk. You must be aware of the risks and be
willing to accept them in order to place responsible, informed trading orders. Don't trade with money you can't
afford to lose.

The Fractal's Edge Stock Trading Method is a system that provides information to assist you in making
informed trading decisions; you are free to disregard the information entirely or to act on it in any manner you
see fit. No representation is being made that any trade based on use of the system's information will or is likely
to achieve profits or losses similar to those discussed in this document or on our web site. While we have done
our best to provide you with a quality product, we must caution you that the past performance of any trading
system or methodology is not necessarily indicative of future results.

WARNING

All content provided on our website is protected by copyright law and international treaties. Unauthorized
reproduction or distribution of this information, or any portion of it, including information in this User's Manual,
may result in severe civil and criminal penalties, and will be prosecuted to the maximum extent possible under
the law.

© Copyright 2004, ALL RIGHTS RESERVED

NOTICE: This publication is designed to provide valuable information. It is sold with the understanding that the
publisher or author is not engaged in rendering legal, accounting, or other professional service. If legal advice
or other assistance is required, the service of a competent professional should be sought.

ALL RIGHTS RESERVED. No Part of this publication may be reproduced, stored in a retrieval system, or
transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise,
without the prior written permission of the publishers.
 Acknowledgements

This course would be incomplete without the work of various scholars, researchers, and technical analysts,
among them R. N. Elliott, W. D. Gann, James Gleick, Edward Lorenz, Benoit Mandelbrot, Edgar Peters, Robert
Prechter, and others, who lay the foundation for atypical approaches to analyzing data for trading the markets.

Quantum Futures acknowledges particularly the work of Bill Williams, Ph. D., whose research and findings are
shared in his book, New Trading Dimensions (J. Wiley and Sons, Inc., Publishers, 1998) [Link]

Professor Williams' pioneering efforts led to the identity, definition, and development of the concept of fractals
as they appear on price charts and as they apply to the analysis of market action. This concept, which
integrates volume, acceleration, and momentum, was seminal to the development of The Fractal's Edge
spreadsheet trading tool. We are indebted to Professor Williams for his contributions to the field, without which
there could be no Fractal's Edge.

For more information about Bill Williams and the Profit Unity Trading Group programs, go to
[Link]

Module 1. Introduction to a Radically New Stock Trading Approach

The Perfect Business
You are about to get into a business that gives you everything you've ever wanted from a business of your own.
It offers the potential for unlimited earnings and, in the course of time, real wealth. What's more, you can run it
working your own hours while continuing to do whatever you're doing now. You operate this business entirely
on your own, and can start with very little capital. You won't have any employees, so you don't need attorneys,
accountants, or bookkeepers. In fact, you'd never have collection problems because you won't have any
"customers," and since there is no competition, you won't have to pay the high cost of advertising. You also
won't need office space, warehousing, or a distribution system. All you need is a personal computer and you
can conduct business from anywhere in the world.

How Do YOU Fit In?

In your business, you become a "silent financial partner" in companies, not because you know anything about,
say, auto parts or pharmaceuticals or aircraft, but because you expect to make a profit on the deal. In fact, most
stock traders have no use for the actual products or services offered by the companies they are financing; they
never even see them. They are just people like you and me; people with a certain amount of capital to invest
getting started in their own business. There are millions of them and they come from almost every profession:
from clerks to executives, from janitors to doctors, from students to university presidents. It is the millions of
traders controlling the millions and millions of shares that allow the stock exchanges to exist. But more than
that, we provide suppliers, manufacturers, and dealers with the capital they need to expand their operations.
For performing this service, we expect to make a profit.

The great thing about all of this is that you don't need a college degree or even a high school education to do
well trading stocks. However, you do need some training, you need an objective system, and you need a plan.
This manual provides everything you'll need to get started, to become successful, and to build real wealth. So if
you're ready, let's get going.

Purpose
The purpose of this coursebook is to help you understand and use The Fractal's Edge, an innovative trading
system for the stock market. While the system is based on Chaos Theory, fractal geometry, and nonlinear
mathematics, the software performs most of the functions automatically. So, you won't need any special ability
with math or computer programming. We will show you exactly how to enter the market data and interpret the
results.

Unique Approach
The Fractal's Edge Stock Trading Method will show you that what happens in the Stock Market is not random.
There is an underlying order behind price movement. As the underlying structure of the stock market becomes
clear to you through an understanding of the principles and methods taught in this course, you will begin to reap
the financial rewards.

The Fractal's Edge (TFE) is unique in that it does not attempt to predict the future. Rather it is a tool that helps
you to recognize and go with the market's current flow. Mastering this system will give you greater peace of
mind because you won't need to keep up with the Fed, pending legislation, interest rates or the opinions of
experts.
 Unlike most other trading systems, TFE does not depend on past performance. Its formulas are not optimized
or curved to fit statistical models. And it doesn't depend on pattern recognition algorithms. One key principle to
always keep in mind is that the past does not equal the future. The future is always constantly replacing the
past.

The Fractal's Edge deals with the here and now, the thin line between the past and future.

So, what does The Fractal's Edge Stock System look like?
Continue on to Module 2 to find out.

Module 2. Visual Display and Descriptions of System Components

The purpose of this module is to provide you with a visual bird's eye view of the The Fractal's Edge Trading
System and to give you a quick description of each component. Figure 1 below shows what you'll see after you
enter the day's trading data. It includes the bar chart, the Gatekeeper, the E-WaveOscillator, the Accelerometer,
the Momentum Oscillator, and the Psychometric Evaluators, which consist of the Volume chart and the Volume:
Range Ratio chart.

By the way, don't let the technical sound of the system component names scare you. They are based on easy
to understand principles that you will quickly learn as you go through the remainder of this course. Each part of
the system works in concert with the others to give you an accurate picture of current market conditions.

While the actual software display has tabs for each indicator, for the sake of convenience, we will show all
indicators simultaneuously, one below the other. In addition, the software does not contain a drawing
component, and all arrows, circles, lines, and other illustrative devices have been added simply for the purpose
of clarification. Below Figure 1, you will see a brief description of the system indicators.

Figure 1. View of Fractal's Edge system graphics.

The Fractal's Edge Stock Trading Software features a visually rich environment that converts user-entered
market data into the following charts and graphics. The following are a description of the components

● A standard price chart: depicts the high, the low, and the close.
● Initiating Fractals: fractal formations appearing on the price chart indicate entry points for further
trading and pyramiding. When combined with the Gatekeeper, these fractals show you where to place
the initial order.
● The Gatekeeper: assists you in preventing unwise trades and signals entry and exit points for valid
trades. It also helps you to know how long to stay with a trend so that you can maximize the profit
potential of your trade. It is comprised of a series of moving average lines superimposed over the
individual stock bar chart. Averages are based on ratios derived through the application of fractal
geometry.
● E-wave Oscillator: confirms that the momentum of a current trend has turnedand that it's time to exit
the market. It is a precise indicator of overall market rhythm. Formulas for this histogram are based on
fractal ratios.
● The Accelerometer: an early warning signal, alerting you to future changes in a market's trend. It is
extremely sensitive to changes in the acceleration or deceleration of market momentum. Formulas are
derivatives of the formula for the Momentum Oscillator.
 ● The Momentum Oscillator: Reading the Financial Pages of Tomorrow's
Newspaper Today by showing the strength and direction of the market's underlying momentum.
Formulas are based on fractal geometry.
● The Psychometric Evaluators: a pair of histograms (Volume and Volume Range Ratio) that work with
the current day's volume to give you a picture of the how the "mass mind" has affected the day's trading.

These components combine to provide you with all of the information you need to make sound trading
decisions. The modules that follow contain detailed descriptions of the system's indicators.

What is Chaos Theory and what does it have to do with making money in the stock market? Read
Module 3 to discover the answer.

Module 3. Chaos Theory 101 - Seeing the Underlying Order of the

Market
This module will introduce Chaos Theory and its application to the markets.

Since the principles found in The Fractal's Edge are based on Chaos Theory and fractal geometry, we'll take a
few moments to briefly explain those concepts and how they are related to trading the stock market.

What is Chaos?

When we think of the word "chaos," we usually think of disorder. But did you know that there are actually
several definitions of the word? The dictionary defines chaos as:

1. a state of utter confusion or disorder.

2. any confused, disorderly mass.
3. the infinity of space or formless matter supposed to have preceded the creation of the universe.
4. the nonlinear, deterministic behavior of certain systems, as the appearance of strange attractors or
fractal structure in graphical representations of a system's evolution.
5. the discipline that studies such behavior.

Webster's Universal College Dictionary. New York: Random House, Inc. 1997.

Throughout this manual, we will use the word chaos as defined in number 4 above (and below):

the nonlinear, deterministic behavior of certain systems,

as the appearance of strange attractors or fractal structure
in graphical representations of a system's evolution.

So, what does that mean?

Let's understand it by examining the meaning of the key words in the definition.

nonlinear

In math, linear refers to measurement in one dimension only (the line); in statistics, the term usually refers to the
prediction of one variable from another-for example, the prediction of next week's IBM prices based on IBM's
performance over the past several weeks or months.

Nonlinear, on the other hand, refers partly to measurement in fractional dimensions. That is, it refers to
dimensions between a point and a line (the zero and first dimension); between a line and a plane (the first and
second dimension); between a single plane and an infinite number of planes (the second and third dimension);
and between a lower structural order and a higher structural order (the third and fourth dimension).

For example, when you look at a price chart, there appears to be some kind of structural order to it, with each
bar in a trend following the other. And even though you can see the general direction the price is moving, you
cannot predict with any degree of accuracy where the price will be tomorrow. This is because there are too
many factors to take into account: government reports, economic conditions, competition, market share, news
reports, you name it. Add to the mix the fact that good news for some traders is bad news for others.

Furthermore, each trader processes and filters these bits of information through his/her own value system, and
then makes a decision to buy, sell, hold, or bail out. So, when you reach the last bar on the right-hand edge of
the chart, there is no way to factor in or even recognize all of the non-linear, LOWER-order variables that
influence trading decisions. The indicators in The Fractal's Edge were designed to help you see the HIGHER
structural order not visible within the lower structural order of the price chart itself.

deterministic behavior

Deterministic behavior refers to a system's underlying structure. It is in that underlying structure that we find a
system's true order. The behavior of the underlying structure, through an extremely complex series of
unpredictably linked events, determines the visible surface structure we see in a complex system. That is what
we mean by deterministic behavior. Thus, while to our eyes, the surface structure appears turbulent, chaotic,
and unpredictable, the underlying structure is extremely orderly, and is actually determining the behavior the
surface structure is displaying.

For example, when we examine a price chart, we are only looking at a picture of the stock's surface structure as
it has been determined by the underlying structure. Just remember that in the end, it is the underlying structure
that determines the direction the price is going, and the ability to see that underlying structure makes the
difference between winning and losing. The Fractal's Edge allows us to see that underlying structure, and thus
to accurately interpret the market's current behavior, regardless of the price on the chart.

strange attractor

The term "nonlinear" also deals with the self-organizing Strange Attractor. The Strange Attractor's main value
is that it allows us to see the order in the underlying structure of highly irregular, complex, and turbulent
systems. It is also extremely sensitive to what Edward Lorenz (1963) terms the Butterfly Effect. That is, even
the smallest change in initial conditions will show up as a huge change in conditions down the road. He
describes the Butterfly Effect this way:

The wing movement of a butterfly in Peru may later, through an extremely complex series of
unpredictably linked events, magnify air movements and ultimately cause a hurricane in
Texas. (p. 8)

This is a radical idea, and very important in playing the market. The Fractal's Edge is based on this
concept. The software indicators: the Gatekeeper, the Accelerometer, the Momentum Oscillator, and the
Psychometric Evaluators comprise the Strange Attractors of our system which reveal to us the underlying
structure of the markets. Powerful indeed! More on the specific indicators later.

fractal structure

Fractal structures exist in complex systems. They are self-similar, determined by definite rules, and repeat
themselves over all scales of measurement. For example, a mountain range contains a series of mountains that
form the peaks and valleys characteristic of all mountain ranges. If we look carefully at the silhouette of one
mountain in the range, we will see that it, too, is irregular in structure, with its own peaks and valleys, and quite
similar to the whole mountain range.

If we go a step further and examine with a magnifying glass the silhouette of a rock that fell from the mountain,
we would see another self-similar fractal of the entire range with its own peaks and valleys. Finally, if we were to
examine under a microscope the silhouette of a very small grain of sand from the rock, we would again see the
fractal image of a mountain range. Even though the grain of sand, the rock, and the mountain are only fractals
of the mountain range, they still contain all the characteristics of the whole.

More on fractals in Module 5.

graphic representation

Charts are a graphic representation of the stock market's system. Because the market is complex and chaotic,
the charts contain fractals that repeat themselves over all scales of measurement. To illustrate, when we look at
a monthly chart (one example of a scale of measurement), we see the typical ups and downs that we would
expect to find on a weekly chart.

Likewise, we will see a similar pattern on the daily chart that we see on the weekly, and so on down to a six-
minute chart. Each chart, over all scales of measurement (monthly, weekly, daily, hourly, and six-minute) is a
self-similar fractal of the next higher chart. What is more, the irregular ups and downs of price movements within
the same chart form fractals as well. It is precisely those fractals that are the key to how the market organizes
itself.

You will see visual examples of this in Module 5 on fractals.

So that, in a nutshell, is why we say that chaos is "the nonlinear, deterministic behavior of certain systems, as
the appearance of strange attractors or fractal structure in graphical representations of a system's evolution."
Another way of saying the same thing in simpler terms would be to say something like, "Complex systems like
the weather or the financial markets may seem chaotic. But there is an underlying order that determines the
visible results that occur within a system. Chaos Theory is the study of the underlying order of complex
systems."

Why apply Chaos Theory to the stock market?

For most of our lives, we have been taught to think in linear, Newtonian terms. We have been led to believe that
for every effect, there is a cause; for every action, there is an equal but opposite reaction. If we want to prove or
disprove a hypothesis, we employ the scientific method, and then analyze our data through the use of statistics.

At the root of all of our statistical tools is linear mathematics with its averages, standard deviations, variances,
confidence intervals, probability estimates, and so on. Outliers, random noise, and data that fail to fit a particular
statistical model are assumed to be part of "measurement error" and while they are "accounted for," they are, in
effect, disregarded. Furthermore, when we apply linear tools or Newtonian thinking to stable, non-turbulent
data, the results are actually very useful.

However, if we assume that linear math is also adequate for analyzing the behavior of such complex systems
as the weather, the flow of traffic in city streets, human brain wave activity or the financial markets, we are
making a big mistake. This is because these systems are nonlinear in nature, and analyzing them
requires a nonlinear approach.

For example, what happens in the market is overwhelmingly influenced by the individual decisions of all active
investors. Since investors base their decisions on their own personal motives, needs, desires, hopes, fears, and
beliefs, the markets, as a reflection of their interaction with the mass of investors, are inherently complex,
nonlinear systems. Yet most market experts ignore this fact when developing trading systems that appear to
work. They analyze decades of charts and employ highly sophisticated linear statistics to "fit" these historical
data to a particular model.

Using such processes has led to pattern recognition programs (head and shoulders, 1-2-3 formations, triangles,
pennants, and so on), as well as to many of the other market indicators such as Bollinger bands (based on
standard deviations), reserve strength indicators, and others. These tools will accurately point to where you
should have entered and exited the market for maximum profit in the past.

However, while all systems and indicators that are based on linear techniques are accurate predictors
of past performance, they do not work well in present time.

Nevertheless, the experts continue to apply linear tools to analyze these nonlinear phenomena, and they
continue to obtain indifferent results (Gleick, 1987).

Thus, the implication for the millions of speculative investors who use techniques, tools and systems based on
linear models is that they are doomed to losing often and winning only occasionally. This is because such
models are grounded in the mistaken assumption that the future will be like the past. But the fact is that every
broker, every publication, every trading system including this one, and every Internet site that deals with trading
publishes this warning: Past performance is not necessarily indicative of future results. The risk of loss
exists in trading the stock market.

However, since Chaos Theory is totally nonlinear in its approach to analysis, it lends itself particularly well to
systems whose behavior appears to be random, unpredictable, and "chaotic." Employing rigorous mathematical
methodology, Chaos Theory is especially useful for revealing the highly ordered underlying structure of
turbulent systems. Take a rapidly running river, for example. The underlying structure of the riverbed, with its
rocks, boulders, trenches, shallows, and sandbars is what produces the rapids, the white water, and the eddies
we see on the surface. If we could see the bottom, we could accurately predict the surface conditions at any
given spot along the river.

The markets are a lot like a river: they, too, have their rapids, their white water, and their eddies. And like rivers,
they also have an underlying structure. If we could see that structure, we could more accurately make sense of
the market charts on our computer screens. And that is the exact purpose for which The Fractal's Edge was
created. It allows us to "see" the underlying structure of the markets.

What's more, TFE allows us to see the Butterfly Effect in action. Here's how:
 ● Price is the very last thing to change in the markets.

● Before there is a major change in price, there is a change in momentum. The Momentum Oscillator
alerts us to those changes.

● Before there is a change in momentum, there is a change in acceleration. The Accelerometer is

extremely sensitive to changes in the speed at which the momentum is moving.

● Before the speed changes, there is a change in volume. This is measured by one component of the
Psychometric Evaluators, a histogram of the raw market volume.

● Before the volume changes, investors make their individual chaotic decisions based on their own
personal motives, needs, desires, hopes, fears, and beliefs. This massive psychological influence is
measured by combining the second component of the Psychometric evaluators, the volume:range ratio
with the raw volume. This is the butterfly's wings, the first event in a series that leads to price change.

Beginning with the investors' decisions, each of these effects sets in motion a complex series of unpredictably
linked events, and each event exerts exponentially more influence on the outcome of the next. Price,
momentum, acceleration, volume, and the mass mind reflected in the decisions of millions of investors are the
rocks, boulders, trenches, shallows, and sandbars of the market's underlying structure. Being able to see the
structure enables us to move in rhythm with the markets, and moving in rhythm with the markets enables us to
make consistently profitable trades.

Recap of Chaos Theory

● Chaos is the nonlinear, deterministic behavior of certain systems, as the appearance of strange
attractors or fractal structure in graphical representations of a system's evolution. Complex systems may
seem chaotic. But there is an underlying order that determines the visible results that occur within a
system.

● The stock market is a complex, chaotic system whose graphical representation is the bar chart.

● Applying linear tools to complex, chaotic systems is a profound error.

● The Fractal's Edge uses Chaos Theory which is a nonlinear approach to analyzing complex systems.

● Nonlinear refers to fractional dimensions, fractal geometry, and Strange Attractors.

● Strange Attractors allow us to see the underlying structure of the market.

● The Gatekeeper, the Accelerometer, the Momentum Oscillator, and the Psychometric Evaluators are the
Strange Attractors of The Fractal's Edge, which keep us aware of the Butterfly Effect of market
conditions (meaning the small initial changes in market conditions that lead to huge stock price changes
down the road).

● Being able to see the underlying structure enables us to move in rhythm with the markets, and moving in
rhythm with the markets enables us to make consistently profitable trades.

References
Brock, W., Hsieh, D., and LeBaron, B. Nonlinear dynamics chaos, and instability: Statistical theory and
economic evidence. Cambridge, MA: MIT Press, 1991.
Casadagli, D., Chaos and deterministic versus stochastic non-linear modeling. Journal of the Royal Statistical
Society, 54, 1992.
Chorafas, D. N. Chaos theory in the financial markets. Chicago, IL: Probus Publishing, 1994.
DeVaney, R. L. An introduction to chaotic dynamical systems. Menlo Park, CA: Addison Wesley, 1989.
Falconer, K. J. The geometry of fractal sets. New York: Cambridge University Press, 1985.
Farmer, J. D. Chaotic attractors of an infinite-dimensional dynamic system. Physica 4D, 1992, pp. 336-393.
Feder, J. Fractals. New York: Plenum Press, 1988.
Gleick, J. Chaos: The making of a new science. New York: Viking Press, 1987, p. 8.
Hofstadter, D. R. "Mathematical chaos and strange attractors." Metamagical Themas. New York: Bantam
Books, 1985.
Lorenz, Edward N. "Deterministic nonperiodic flow." Journal of the Atmospheric Sciences. 20:130-41. 1963.
Johnson, R. A. and Bhattacharyya, G. K. Statistics principles and methods. New York: John Wiley and Sons,
1996.
Ramsey, F. L. and Schafer, D. W. The statistical sleuth: A course in methods of data analysis. Belomont, CA:
Duxbury Press/Wadsworth /ITP, 1997.
 Module 4. The Bar Chart - What to Look For When Considering a
Market to Enter.
In this module, you will be introduced to the price bar chart, how it works and what to look for when
exploring possible markets in which to invest.

Bar charts depict time in two dimensions: the vertical and the horizontal. The vertical dimension carries
information about what happened to the price of the stock during a single time period (in 6- or 10-minute
intervals for an hourly chart, in one-day intervals for a daily chart, in one-week intervals for a weekly chart, and
so on). The horizontal dimension carries visual information about the price history, hour after hour, day after
day, so that we can see the general direction that the market is traveling.

The individual bars look like this:

The vertical line (bar) represents the range that the price traveled during that time frame. The bottom of the bar
indicates the lowest price reached during that same time frame (hour, day, week, etc.), while the top of the bar
indicates how high trading took the price. Finally, the small horizontal line indicates the price at which the
market closed during that particular time frame.

The position of the close, relative to the high and the low, also tells us who (buyers or sellers, bulls or bears)
was in control of the market at the end of the day. In the example above, because the close is in the upper third
of the bar, we would say that the bulls (those investors expecting the stock to trend upward) were in control. If
the close had been in the lower third of the bar, then we would say that the bears (those traders expecting the
market to trend downward) were in control. And, if the close were in the middle of the bar, we'd have to call it a
draw.

Figure 2 below is a daily bar chart for Anheuser-Busch. It contains approximately 130 bars, each depicting the
events of a single day in the life of this stock. All the bars successively represent about six months of market
activity, and together they delineate the approximate direction the market is heading.

Figure 2. Daily bar chart for Anheuser-Busch (BUD).

However, while we can see where the market has been up to now and the apparent direction it is taking,
anyone who spends time in the market knows that past performance is no guarantee of future results. In fact, as
traders, we are always left with what Elder (1993) calls "the hard right edge of the chart." For most traders, that
is the area of greatest uncertainty, for no matter how hard we try, we cannot predict the future. The one thing
we do know for sure is that prices can only move up, down, or sideways-they don't go backwards, and they
don't stand still.

We also know that the market spends from 70% to 85% of its time moving in narrow, sideways channels, or
"trading ranges" (Roberts, 1991; Williams, 1998 ). Technical analysts describe these channels as having a
lower and an upper boundary beyond which the price "refuses" to move. In an upward-trending market, they call
the lower boundary "support" and the upper boundary "resistance."

The reverse is used for downward-trending markets. It is precisely in this area of the market's life that most
traders lose. They spend the majority of their time entering and exiting a market that is going nowhere. They are
hoping to get in on the very beginning of a trend by anticipating a "breakout" from the channel. But time and
time again, they come up against the "hard right edge" of the chart, with no way of knowing whether the
"breakout" (a price move above or below resistance) is real or not. To get a clearer idea of this quandary, let's
look at the "generic" sideways movement of the market depicted in Figure 3.

Figure 3. A channeling (range-bound) stock

Remember, this is how the market spends 70% to 85% of its time, and at the hard right edge of the chart,
uncertainty reigns, and anything is possible. Keep in mind that a great deal of energy is stored in that channel,
so when a trend begins, there is a lot of steam behind it.

Figure 4 shows a trend that began as a "breakout" from the channel. Pretend for a moment that you were
interested in this stock. You had no way of knowing for sure what direction the trend would take, but from all of
your research, you were sure the price would be dropping. So when the breakout was to the up side, you were
caught off guard and missed getting into the market early.

Figure 4. A trending stock after a "breakout"

 Module 5: The Fractal - Key to Understanding How the Markets
Organize Themselves
In this module, you will learn what fractals are and how to use them to identify profitable entry points
into the markets.

Since our approach to the markets involves Chaos Theory and its application through fractal geometry and
nonlinear mathematics, it would be well for you to have at least a layman's grasp of what fractals are and how
they relate to stock trading.

Simply put, fractals are self-similar patterns that repeat themselves. Each sub-unit of a fractal resembles the
over-all pattern of the entire fractal.

Fractals frequently appear in nature. For example, take a look at the computer generated image of a fractal
below. Look like anything you might have seen in real life? Notice that the shape of each individual petal is in
the same shape as each leaf which, in turn, is in the same shape of the entire limb.

That's a fractal.

If you start looking around, you will begin noticing fractals everywhere: in the clouds, in bird's wings, in the physical
structure of DNA, in mountain ranges, in the human nervous system, the blood system, root and branch systems of
trees, the order of planets and stars, the atomic structure of matter AND in the markets themselves. It's one of the
key ways that nature uses to grow, organize and repeat itself. Because the markets share the same properties and
behaviors as naturally occurring fractals, we can begin to see how the markets organize themselves and use that
information to make effective trading decisions.

Fibonacci Ratios
Fractals come into being through a process called iteration, or iterative accretion (addition). That is, one effect is
added to another effect, and the sum of those two becomes a larger effect that is added to yet another one, and on
into infinity.

Pioneers of Chaos Theory in the markets were looking for patterns in the way fractals form. They employed
supercomputers to perform calculations so complex that they required a rocket scientist's understanding of nonlinear
equations. Then, Williams (1998), in his seminal work on applying chaos theory to trading, discovered certain ratios
among moving averages that very closely approximated the earlier, more complex formulas. These ratios, in turn,
are relatives of Fibonacci numbers.

Fibonacci numbers are probably the earliest model of iterative accretion, and are a summation sequence that looks
like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55…..infinity. If you add any two adjacent numbers in the sequence, the result
will be the next higher number. The interesting thing about the relationship of the numbers in the sequence is that
beginning with 3, each number is approximately 62% of the next number, no matter which two numbers you use.

Not only that, but if you convert three or more consecutive ratios to decimals (5/8=.6250; 8/13=.6154; 13/21=.6190),
subtract the adjacent results and use their absolute values (.6250-.6154=.0096; .6154-.6190=.0036), divide the
smaller of the remainders by the larger (.0036/.0096=.3810 after accounting for rounding error), and add that result
to the last number in your original three, you'll get a perfect 1.00. In addition, you will have seen two very important
numbers: 62% and 38%.

According to Barnsley (1988), these numbers are found throughout nature. Seed patterns on flowers, the ratio of the
heart's contracting and resting length, the Nautilus shell, or the location of the human navel at 62% of a person's
height, are all examples of Fibonacci relationships. These same relationships are also the basis for many of the
calculations used in The Fractal's Edge.

The Elliot Wave

R. N. Elliot, a pioneer in pattern recognition, discovered that the market moves to the rhythm of a sequence of five
impulse waves that travel in the direction of the current trend, and three corrective waves that travel in the opposite
direction. Figure 5 illustrates this series on a daily chart. His discovery became known as Elliot waves, and they are
awash with Fibonacci relationships.

Figure 5. The Elliot Wave on a daily chart

Williams had been analyzing the behavior of the Elliot wave because he believed that it represented the underlying
structure of the market, and that the fractal was the underlying structure of the Elliot wave. According to Williams,
the market's rhythm is similar to the sequence of waves depicted in Figure 5 above, but with these interesting notes:

● Wave 1 marks the beginning of a trend in a new direction. It is usually short and is preceded by a change in
momentum.

● Wave 2 is a price correction wave that will retrace approximately 38% of Wave 1. It is caused by traders who
don't realize that a new trend has begun. In the case of Figure 5, they enter the market on the mistaken
assumption that Wave 1 is just another corrective wave in a continuing downward trend, so they sell at the
top of Wave 2, and are generally wiped out as Wave 3 develops.

● Wave 3 is the most powerful in the sequence. It will generally be at least 68% longer than Wave 1 and its
slope is usually steeper than the other waves. Wave 3 is also fueled by heavy volume, and has the potential
to be the most profitable in the sequence.

● Wave 4 is a price correction wave that will retrace 38% - 50% of Wave 3. It can be more irregular and
somewhat longer in terms of time than the other waves. Wave 4 is caused by profit taking after Wave 3.

● Wave 5 is the last wave in the trend. It represents one last effort to reach new high (low) prices. While it
appears to be another powerful thrust in the direction of the current trend, its slope is generally not as steep
as that of Wave 3, and it is not accompanied by heavy volume.

● Waves a, b, and c are corrective waves. Wave a may extend below the end of Wave 4, Wave b will retrace
 about 38% of Wave a, and Wave c will retrace about 68% of Wave 3.

In our earlier definition of a fractal we said that each chart, over all scales of measurement (monthly, weekly, daily,
hourly, and six-minute), is a self-similar fractal of the next higher chart. Figure 6 depicts the Elliot Wave sequence of
an hourly chart superimposed over the Elliot Wave sequence on the daily chart we saw in Figure 5.

Figure 6. The Elliot Wave on an hourly chart superimposed over a daily chart

Look at daily Waves 1 and 2 in Figure 6. Can you count the sequence of hourly Waves 1-5 and a, b, c? Figure 7
shows you a clearer picture.

Figure 7. Close-up of The Elliot Wave on an hourly chart superimposed over a daily chart

What you are really looking at is the fractal relationship between the two time periods. And what is more, you are
getting a glimpse of the market's underlying structure.

Fractal Formations
The irregular ups and downs of price movement within the same chart form fractals as well. Williams (1998)
[[Link] was the first to identify, define, and develop the concept of fractals as they appear on price
charts and as they apply to the analysis of market action. He observed that it is precisely those fractals that are the
key to how the markets organize themselves. And it is those fractals that we will most closely study, because we will
work with them every day. This type of fractal is composed of at least five consecutive bars, three with higher highs
(or lower lows) followed by two with lower highs (higher lows).

Figure 8 illustrates this ideal fractal pattern (the two on the far left labeled "A") and depicts several variations as
well. Notice that in every case, the fractal bar (the one with the arrow) is higher (lower) than the two bars preceding it
and the two bars following it.
 Figure 8. Frequently-occurring fractal formations

Fractal Formations and the Elliot Wave

It is important to remember that fractals form in response to a change in mass trading behavior. For example, as the
market moves up, there will come a time when there will be no buyers willing to enter the market. Consequently,
prices begin to fall because no one wants to buy. Then Chaos, in the form of some new bit of incoming information,
motivates further buying and the market moves up again.

Illustration B is an example of what this behavior might look like on a chart.

Furthermore, what we are seeing between each of the up and down fractals is an Elliot wave of some degree. For
example, if we look carefully at illustration "B" above, we can see what might be a Wave 1 developing over the last
17 bars on a daily chart. Can you see the five Elliot waves that would be found in an hourly chart covering the same
17 days?

Illustration C makes these waves more visible.

Illustration D, below, is an example of the Elliott Wave sequence on a daily chart of the Dow Jones. The numbered
boxes correspond to each of the waves in the series. In the E-Wave oscillator, the waves are measured roughly
from where the blue signal line separates from the bars at the last peak below (or above) the zero line to where it
separates from bars at the last peak above (or below) the zero line. The red circles within the E-Wave oscillator
highlight the approximate beginning and end of wave 3. More on the E-wave oscillator in Modules 10 and 11.

Illustration D. The Elliott Wave sequence on a daily chart (DJ, 1/28/03 - 2/23/04)
Since we will always use the fractal as the fundamental signal for entering the market, the following sequence of
illustrations will show you how, in a trending market, we do this.

When we use the word "tick," we mean units of price, usually cents. In Illustration 2, for example, if the price for the
stock represented by the high of the fractal were 9.50, we would enter an order to buy a number of shares at 9.52.
Let's suppose that this is the case with Illustration 2 below. The first buy fractal was formed after the fifth bar, so we
would place an order to buy a number of shares at 9.52. Since we don't know whether the price will rise or fall, we
may also want to sell short as well.

The first sell fractal formed after the seventh bar, at 8.70, so we would also enter an order to sell short a number of
shares at 8.68. We now have two active orders: one to buy and one to sell. If one order is filled, the other will be
cancelled. So now we can sit back and see what develops, because we don't really care what direction the market
takes.

In Illustration 3, the first buy fractal was "hit" on the ninth bar, so our buy order was filled and our sell order was
cancelled. We now have one active trade. The second buy fractal, formed after the 12th bar, was at 9.75. We would
again go long the market (place another buy order for a number of shares) at 9.77. This fractal was hit the next day,
on the 13th bar. Our buy order was filled, and now we are long the market two times the number of shares. The 13th
bar was also a sell fractal, but we would ignore it and all sell fractals for now. We could continue adding shares as
each fractal was hit, until the trend changes, or proceed with only the shares we had bought up to that point.

The scenario above illustrates how we use fractals to enter the market and to add shares to our trading business as
the market continues to trend. A major problem with relying only on the fractals is that we have no clue as to when
the trend may change, or even whether the market is trending. For all we know, the chart in Illustration 3 above is
actually range bound between the lowest fractal and the highest. It is entirely possible that the entire scenario could
play itself out as depicted in Illustration 4 below. With this type of market behavior it is impossible to keep any gains
you might make and you could find yourself whipsawing all over the chart. So, while the fractal is a very powerful
indicator of where to enter the market and where to add more shares, it is only useful when used in conjunction with
the rest of the tools in The Fractal's Edge.

Review of Fractals

● Fractals come into being through a process called iteration, or iterative accretion (addition).

● Fibonacci numbers are probably the earliest model of iterative accretion, and are a summation sequence that
looks like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, . . .infinity.

● Fibonacci ratios are found throughout nature. These same relationships are also the basis for many of the
calculations used in The Fractal's Edge.

● The Elliot Wave consists of a sequence of five impulse waves that travel in the direction of the current trend,
and three corrective waves that travel in the opposite direction.

● Elliot waves contain Fibonacci relationships.

● The Elliot Wave represents the underlying structure of the market, and the fractal is the underlying structure
of the Elliot wave.

● The bar chart of a lower time frame is a fractal of the next higher time frame.

● The irregular ups and downs of price movement within the same chart form fractals. Those fractals are the
key to how the markets organize themselves.

● This type of fractal is composed of at least five consecutive bars, three with higher highs (or lower lows)
followed by two with lower highs (higher lows). The middle bar in the series is higher (lower) than the two
preceding and two following bars.

● What we are seeing between each set of up and down fractals is an Elliot wave of some degree.

● Fractals are used to locate entry points into the market, and points at which to add to our shares.

● While the fractal is a very powerful indicator of where to enter the market and where to add more contracts, it
is only useful when used in conjunction with the rest of the tools in The Fractal's Edge.
 References
Balan, R. Elliott wave principles applied to the foreign exchange markets. London: BBS Publications, Ltd., 1989.
Barnsley, M. Fractals everywhere. San Diego, CA: Academic Press, 1988.
DeMark, T. R. The new science of technical analysis. New York: John Wiley and Sons, 1994.
Elder, A. Trading for a living. New York: John Wiley and Sons, Inc., 1998.
Elliot, R. N. The wave principle. Elliott, 1938.
Mandelbrot, B. The fractal geometry of nature. New York: W. H. Freeman and Co., 1983.
Murphy, J. J. Technical analysis of the futures markets: A comprehensive guide to trading methods and applications.
New York: New York Institute of Finance/Prentice Hall, 2001.
Peters, E. Fractal market analysis. New York: John Wiley and Sons, 1994.
Prechter, R. R. and Frost, A. J. Elliott wave principle: Key to stock market profits. Chuppaqua, New York: New
Classic Library, 1978.
Roberts, Ken. The world's most powerful money manual and course. Grant's Pass, Oregon: The Ken Roberts
Company, 1991.
Wallach, P. Wavelet theory. Scientific American. January, 1991.
Williams, B. New trading dimensions: how to profit from chaos in stocks, bonds, and commodities. New York: John
Wiley and Sons, Inc., 1998.

Module 6. The Gatekeeper- Staying Out of Trouble

This module will teach you how to use the Gatekeeper as a tool to assist you in deciding when it is safe to
enter the market and when it is time to exit. This tool will also help you to know how long to stay with a
trend so that you can maximize the profit potential of your trade.

The Gatekeeper is a series of three Stability Lines that combine to help us know when to enter the market, when to
stay with the current trend and when to exit the market. The Stability Lines are based on fractal geometry and
nonlinear mathematics. (See Figure 9 below.)

Figure 9. The Gatekeeper

 In his system, Williams (1998) calls this combination of moving average lines the Alligator. Each of the
Alligator's moving averages is based on Fibonacci ratios. For example, Williams' "Balance Lines" were
constructed using time frames that are each approximately 62% of the next higher frame. However, we have
chosen to use a derivative of the Fibonacci sequence that is obtained by applying an additional computation
that also allows an iterative accretion of the Fibonacci sequence to occur.

So, while the Gatekeeper's Stability Lines are based on time frames that are each about 62% of the next
highest time frame, they were constructed using an alternative sequence of moving averages. This adjustment
allows us to be more certain about where a trend is beginning or ending, and more precise in entering and
exiting the market.

The Wall
Figure 10 below shows the interaction of the three Stability Lines with the bars on a daily chart. The blue
moving average line (The Wall) represents the time frame we are currently trading (hourly, daily, weekly, and
so on) and indicates where the price would be if there were no new information (chaos) coming in. It marks the
boundary between stability and chaos, and is like a high stone wall that the price must clear before it makes a
major change in direction. In fact, we call it "The Wall."

The Tripwire
The red moving average line, or Tripwire, is the Stability Line of one significant dimension lower. If the Wall is
on the daily chart, the Tripwire is on the hourly time frame. We call this line the Tripwire because it provides an
early warning that the trend may be changing. If the price closes between the Tripwire and the Wall (the red and
blue Stability Lines), it is a warning to exit your trade. However, since all of the constituents of The Fractal's
Edge should be used together, the other components may indicate only that you tighten your stops. You'll learn
more about this later.

The Picket Fence

The green moving average line, or Picket Fence, is the Stability Line of yet another significant time frame
lower. It's like a little Picket Fence that warns you to keep a safe distance from the Tripwire.

Figure 10. Interaction of the Stability Lines on a daily chart (CocaCola Enterprises - CCE, 11/31/99 - 3/28/2000)

As bars begin to cross the Picket Fence and get into the Tripwire, the Gatekeeper closes the gate on trading,
and the gate remains closed until the price has enough momentum to "escape" over the Wall.

The signal that the gate is closed is when any two, or all three Stability Lines cross over one another.

As long as they remain intertwined, the gate is closed (see the area marked 1 in Figure 11 below). When a bar
"escapes" over the Wall, it could be a signal that a new trend is forming (see area 2). Remember, however, that
price is always the last thing to change. To take full advantage of the Butterfly Effect, all of the components of
The Fractal's Edge should be used together.
Figure 11. Interaction of the Stability Lines on a daily chart (CocaCola Enterprises - CCE, 11/31/99 - 3/28/2000)

Entering the Market: The Gatekeeper and the Breakout Fractal

Recall that earlier we said that the market spends 70% to 85% of its time in a narrow, range-bound channel, and at
the hard right edge of the chart, uncertainty reigns, and anything is possible (see Figure 12 below).

Figure 12. A range-bound market

Figure 13 below is a real-life example of a range-bound, channeling market found in the Johnson and Johnson (JNJ)
chart. We are ideally looking for a market that is moving in a narrow, sideways channel because a great deal of
energy is stored there. When a trend begins, there is a lot of steam behind it and this is where the greatest
opportunity for profit exists. It is also the most basic of the techniques taught in this course.

For example, as you study Figure 13 (Johnson and Johnson--JNJ) below, you will notice that this is an example of
a range-bound market. The channel is identified by the blue lines.

Also, as you look at the hard right edge of the chart, you will see that the Gatekeeper has closed the gate as signified
by the intertwining Stability Lines. Many of the bars so far have been "captured" by the Gatekeeper, indicating that we
don't want to be in the market right now because if we enter the market while it's channeling, at best, we may break
even, and at worst, we will experience the whipsaw effect--that is, getting bounced in and out of the market for a loss.

However, when we find this type of narrow, range-bound channeling market with a closed gatekeeper on the hard
right edge, we want to pay attention so that we can set ourselves up in a position to profit when the market breaks out
 and moves beyond the channel.

At no time do we want to try to outguess the market, predict the future, or have any preconceived notions of what the
market is going to do. And that is the great thing about using the Gatekeeper in conjunction with the fractal. We don't
have to worry about which way the market moves. It will go where it wants to go and we always want what the market
wants. At the moment, we have no idea whether the market will break to the upside or the downside, or whether it will
continue channeling.

So, how do we determine where the trend begins, and where to enter the market for the greatest profit
potential?

Simple, we use the gatekeeper and the fractal together.

On the chart in Figure 13, the channel is identified by the blue lines. Your task is to identify the latest buy fractal and
the latest sell fractal by placing an arrow above the buy fractal bar and below the sell fractal bar. The rule of thumb in
trading stocks is that we count as buy or sell fractals only those where the fractal bar is outside of the Gatekeeper's
nearest Stability Line. Remember to draw a horizontal line from the top of the buy fractal and the bottom of the sell
fractal to the right edge of the chart. Compare your work with what we did in Figure 14.

Figure 13. A range-bound, channeling market (JNJ, 9/28/2001 - 2/15/2002)

Figure 14 shows where the latest buy and sell fractals are located on the chart. We will use these as our entry
points until newer buy or sell fractals are formed. We have also drawn horizontal lines from both fractal bars
toward the right edge of the chart. We then place buy and sell orders for two ticks above the buy fractal (58.89
+.02) = 58.91 for the buy fractal , and two ticks below the sell fractal (54.70-.02) = 54.68.

In this case, the buy order would be at 58.91 and the sell order would be at 54.68. Now that our orders are in
place, all we have to do is go with the flow as we watch for new fractals to form, or for a breakout to occur.
Because we are not locked into any particular position, we don't really care which way the market decides to go,
because whichever way it goes, we're going with it. Remember we are monitoring the underlying structure of
the market, but the fractal and the Gatekeeper are only a part of the tools that help us do that. To get the whole
picture, we'll be watching the Psychometric Evaluators, the E-Wave, the Accelerometer, and the Momentum
Oscillator for the Butterfly Effect.

Figure 14. Identifying the latest buy and sell fractals (JNJ, 9/28/2001 - 2/15/2002)
 Contrast Figure 14 with Figure 15 (a breakout). Notice that the gate is now wide open and the price has
crossed our line.

Figure 15. The breakout (JNJ, 10/12/2001 - 2/28/2002)

Our buy fractal has been hit, we entered the market long at 58.91 as we had planned, and watched the market
close at 59.40. This means that today we grossed $.49 cents per share. On 100 shares, that would be $49.00.
You may be thinking that this is pretty easy, and you're right. It is easy to make money in the market, but it's
another thing to keep it. We'll also teach you how to do that.

But for the time being, let's look at what has happening in the market since we began financing Johnson and
Johnson. The box in Figure 16 shows the last fifteen days of activity, during which we have seen the price rise
from 58.91 (our entry point) to a current closing price of 64.60. This advance has caused us to gain $5.69 per
share for a dollar value of $569.00 on 100 shares. Not bad for fifteen days' "work!" Just another friendly
reminder here-it's not making the money that we have to concentrate on, it's keeping your profits that matters.

Continue reading to find out how you do that.

Figure 16. Johnson and Johnson after a breakout (JNJ, 10/29/2001 - 3/15/2002)
 Take a good look at what has happened so far inside the box in Figure 16. Notice that while a couple of bars
have walked along the Picket Fence(the green Stability Line), none of them has seriously crossed it.

Furthermore the current bar is relatively far away from it. At this point, it would be easy for most traders to
assume that a trend is in the making, and that it's probably not going to stop, at least over the next couple of
bars. In fact, most traders will fervently want what they want-that is, for the prices to continue rising. However,
we're interested in wanting what the market wants, and in going where the market takes us. Again, we want to
be in a position to not care what the market does. Since all of the tools in The Fractal's Edge combine to make
us aware of the market's underlying structure, we are not burdened by preconceived notions.

The Stop Loss

Nonetheless, here we are, at the hard right edge of the chart, with the current bar's close at 64.60, looking at
what is apparently an upward trend. And, we're sitting there with a gross profit of $5.69 per share ($569 on 100
shares).

What do we do to protect that gain?

This is where the "stop loss" comes in. The term is actually a misnomer, though, because it is really just another
buy or sell order. However, it has two purposes. First, it minimizes our risk and gets us out of bad trades early.
Second, it protects our profits. It works like this: In our scenario so far, the market has closed at 64.60 giving us
a gain of $569 on 100 shares. We know that eventually the market will change direction because there will
come a point when there are no buyers willing to enter the market, and then prices will fall, and a fractal will
form.

What you can't see on the chart at this point are the other components of The Fractal's Edge. We'll get to
those later on in the course, but for now we'll just tell you that the Psychometric Evaluators are indicating a
change in the mass mind, and the Accelerometer is alerting us that the speed of the current momentum has
slowed quite a bit.

In other words, although the momentum has not yet changed direction, the underlying structure of the market is
changing, and the upward movement of price is slowing.

To remain in the market when the price changes direction, and to protect our profits, we need to decide how
much of our gains we are willing to risk. We can trade conservatively using the Picket Fence, or more
aggressively using the Trip Wire, or highly aggressively using the Wall. For the purpose of illustration, we'll take
the conservative approach and use the Picket Fence. We examine the chart carefully and place a sell stop (an
order to sell) at 64.00.

Now, how did we arrive at this number?

Well, we simply look up the value of the Fence in the table of indicators and values to the right of the price chart
(see Figure 17 below). When we place the stop loss order, we tell the broker that it is Good Till Cancelled
(GTC)--this will be important, as you'll see later in the course. The stop loss should be reset daily to maximize
your gains. As you update your stop-loss from day to day, just tell the broker to cancel the previous stop order
and replace it with your current one.

Figure 17. Determining a stop loss point.

 So, after looking up the stop-loss point, we simply call our broker and tell him/her to place a sell stop at 64.00
(Good Till Cancelled--GTC) for our current trade. If the market falls back to that price, then we are "stopped
out," which means that our shares would be sold at 64.00, and we would get the difference between our exit
price and our original entry point of 58.91. In the process we would have exited the market with $509 of our
gross profit still intact.

Exiting a Trade
So, let's see what happened in the next couple of days after setting our stop loss and adjusting it each day the
market moves in our favor. Figure 18 shows us the results of using the Picket Fence as a way to calculate our
stop loss point. Notice that within the following four days, the market did pull back and fall below the most
recently adjusted stop loss. Because we continued moving our stop loss point each day, we had raised it to
64.45.

Our stop was hit (the low went below 64.45), so we're out of the market with a $554 gain in account equity.

Figure 18. JNJ after calculating stop loss

 Another thing that you should be noticing is that as the subsequent bars begin crossing the Picket Fence, the
Gatekeeper starts closing the gate on them (Figure 18, all bars to right of green arrow).

We also use the GateKeeper histogram to provide another confirmation of the gate's status. It is actually a
histogram of two of the three Stability Lines that make up the Gatekeeper, adjusted to give us an early warning
of the gate's closing. Observe that the GateKeeper histogram broadens as the gate is opening (blue arrows),
and narrows as the gate is closing (red arrows).

As the gate narrows (i.e., the stability lines get closer together), the price bars will eventually come in close
proximity to the Tripwire, and if our current bar crosses it, we want to be getting out of the market quickly, even
if our stop has not been hit. In no case do we want to remain in our position when bars are crossing the
Tripwire, unless we are extremely aggressive in our trading, and are using the Wall as the stop loss point.

The GateKeeper histogram also gives us the advantage of seeing approximately where channels are located.
We can easily identify channels whenever a series of histogram bars does not extend more than one gridline
from the zero line the gate is closed. This is illustrated by the dotted lines in Figure 18b. The longer the
histogram remains within one gridline from the zero line, the longer the channel, and the more potential we have
of getting in on the beginning of a significant price move.

Figure 18b. Dashed lines illustrating a channeling market.

That's it for the nuts and bolts basics. However, this basic technique for entering a trade is not enough to
sustain profits. Our purpose in beginning here has been to help you identify fractals and familiarize yourself with
the Gatekeeper. In the above exercise, it could have been the case that the sideways channel continued, and
that we would have entered our trade only to be whipsawed out. Thus, to make consistent profits, you must
understand and use all of the tools that make up the system.

For the rest of this course, we will be outlining the procedures for going long the market. While shorting the
market uses the same principles, there are some restrictions. These restrictions are not insurmountable but do
involve shorting only shares valued above $5.00, borrowing shares, maintaining a higher margin (60% or more)
based on perceived risk, and having to wait for an order to be valid only after an up tick or a "zero plus" tick
occurs, to name a few. For further advice on selling short, contact your broker.

For more specific information on short-selling with TFE, refer to the special addendum at the end of the
course, entitled, "How to Use TFE to Profit from Down-Trends."

Review of the Gatekeeper

We have taken you through this series of CCE charts so that you can see how the Gatekeeper functions with
fractals in helping us find the correct entry and exit points for trading profitably.

Gatekeeper Components

The Gatekeeper is a series of three Stability Lines that combine to help us know when to enter the market,
when to stay with the current trend and when to exit the market. The Stability Lines are based on fractal
geometry and nonlinear mathematics.

● The blue Stability Line, otherwise know as the Wall, represents the time frame we are trading.

● The red Stability Line, or Tripwire, represents the next significantly lower time frame.

● The green Stability line, or Picket Fence, represents a time frame that is two degrees lower than the one
 we are trading.

The GateKeeper histogram in conjunction with the Stability Lines:

● provides another confirmation of the gate's status (open/closed).

● gives an early warning that the gate is closing.

● indicates approximately where channels are located.

Entering the Market

When making our initial entry into the market, we do the following:

● look for a range-bound market where all Stability Lines are intertwined.

● locate the latest buy fractal whose low is above the nearest stability line, and the latest sell fractal whose
high is below the nearest stability line.

● place a buy order for two ticks above the high of the fractal buy bar and a sell order for two ticks below
the low of the fractal sell bar.

● wait for the breakout bar to cross either your buy entry line or your sell entry line and be sure that the
gatekeeper is open, meaning that the stability lines are not intertwined. For long entries, this means that
the green line is above the red line, and the red line is above the blue line. For short entries, this means
that the blue line is above the red line, and the red line is above the green line.

The Stop Loss

● The purpose of a "stop loss" is to:

1. minimize our risk by getting us out of bad trades early, and
2. to protect our growing profits.

● To obtain a conservative stop loss that will protect our profits and keep us in the market:
❍ use the value found opposite the Fence

❍ call your broker and place a sell stop if you are long (buying) or a buy stop if you are short

(selling).
❍ Repeat the process each day the market is moving in your favor.

● To obtain a more aggressive stop loss that will protect our profits and keep us in the market longer, do
the following:
❍ Use the value opposite the Trip Wire.

❍ call your broker and place a sell stop if you are long (buying) or a buy stop if you are short

(selling).
❍ Repeat the process each day the market is moving in your favor.

● To calculate a very aggressive stop loss that will protect our profits and keep us in the market quite a
long time, do the following:
❍ Use the value opposite the Wall.

❍ call your broker and place a sell stop if you are long (buying) or a buy stop if you are short

(selling).
❍ Repeat the process each day the market is moving in your favor.

● We automatically exit a trade if our stop loss is hit.

● Unless using the Wall as a stop loss point, always exit a trade if the current bar closes across the
Tripwire (between the red and blue Stability Lines).

References
Beltrami, E. Mathematics for dynamic modeling. Boston: Academic Press, 1987.
Davis, R. E. and Thiel, C. C. A computer analysis of moving average applied to commodity futures trading.
 West Lafayette, IN: Ouiatenon Management Company, 1969.
Kaufman, P. J. The new commodity trading systems and methods. NY: John Wiley and Sons, 1987.

Module 7. The Psychometric Evaluators - Key to "Reading" the Mass

Mind
In this module, you will discover how the Psychometric Evaluators give you an indication of what's
going on in the mass mind of all the traders in a particular market.

When you make a decision to buy, sell, enter, or exit, or stay, that decision is combined with the decisions of all
the other traders in the market. Remember that the first effect in the chain of events leading to a change in
market direction is the cumulative effect of all those decisions. The Psychometric Evaluators help us get some
idea as to what is going on in the mass mind.

What are the Psychometric Evaluators?

The Psychometric Evaluators are a pair of histograms that depict the current day's volume and a ratio of the
current volume to the day's trading range. These graphs work together to give us a picture of the how the "mass
mind" has affected the day's trading. Figure 19a shows you what they look like.

Figure 19a. The Psychometric Evaluators

We use the Volume histogram to compare the current day's volume with the previous day's volume. The bar
that is farthest to the right represents the most recent day's volume. The bar immediately to the left of the most
recent day's bar shows the previous day's volume. On the volume chart, those are the only two bars we are
concerned about. If today's volume bar is higher than yesterday's, it is colored green. If it's lower, it is colored
red.

Look at examples 1 and 2 below.

The main idea here is that we want a visual means of measuring today's trading volume in relation to
yesterday's. Before a trend can start, more orders have to be coming in to the trading floor. An increase in
volume always comes before a change in momentum, and momentum always changes before the market
direction changes. So, it is crucial to be able to detect differences in volume because they reflect the combined
decisions of all the traders in the market.

The Volume:Range Ratio Histogram (VRR)

As we have already said, when volume goes up, more orders are coming to the trading floor, and when the
volume goes down, fewer orders are coming in. Detecting changes in volume is important, but it is only half of
the story. We also need an accurate way to see how these changes in volume are affecting the market.

Williams (1995) [Link: [Link]] developed the Market Facilitation Index (MFI), a simple and accurate
measure of how well the market facilitates the movement of price through time. It is used all over the world and
is included as a standard indicator in several technical analysis systems.

Williams' MFI is really a measure of how much each trade moves the price over the day's trading. It is
calculated using intra-day tick volume, which is the number of price changes occurring over a given amount of
time. According to Williams, there appears to be no significant difference in the relationship between the
number of price changes in a given period, and the actual volume of contracts traded. In describing his MFI,
Williams notes that the current period's tick volume must be 10% above the previous period's tick volume for a
green bar, and 10% below to be a red bar. He deems tick volumes between 91% and 109% of the previous
volume to be the same.

In The Fractal's Edge, the Volume:Range Ratio (VRR) is calculated by dividing the price range by the actual
volume, and is a very straightforward computation. The program performs the calculation automatically.

And, as we did with the Volume histogram, we color the bars in the VRR histogram red or green depending on
whether the current day's value is greater or less than the previous day's. The value of this indicator lies in its
ability to measure how willing the market is to move the price and how efficient the market is during the current
bar. Therefore, the only thing of real importance is whether today's bar is green (today's VRR is greater than
yesterday's) or red (today's VRR is less than yesterday's).

It is important for you to grasp the concept that VRR values are only relative. That is, if today's VRR is .0015,
that value is important only compared to yesterday's VRR of .001. Likewise, yesterday's VRR has value only
relative to today's VRR. They don't have any meaning if compared to any other VRR values, because they are
concerned only with what is happening TODAY.

Combining Volume and VRR

An increase or decrease in volume tells us whether more of fewer traders are entering the market, and an
increase or decrease in VRR tells us how the market is reacting to the changes. When we combine the Volume
and the VRR, we have a tool that gives us powerful insight into the mass mind.

Think of the market as a river that you're planning on rafting down. It's a river that is perfectly safe if you
understand the structure of the riverbed and know what to look for along the way; and it's perfectly treacherous
if you don't. Imagine the four combinations of green and red bars as signs, posted on the bank, that describe
the bed of that river. You are not able to actually see the riverbed, but all along the shore there are
combinations of green and red signs that tell you what's happening underneath. The table below describes the
signs and their meanings.
 Let's take a trip down the river as we examine these four combinations of signs in more detail.

Figure 19b. The Psychometric Evaluators (Green-Green) with price chart (JNJ, 10/15/2001 - 3/07/2002)
 Green-Green

Imagine that we're in a quiet pool just off the main stream. If we look down river, we can see that there is a fork
ahead. In front of us are two signs, and both are green. If we understand the signs, what do we know about the
river? Well, we know that the riverbed is smooth, deep, and running down hill. We also know that there is a high
volume of water and the undercurrent is swift and very strong. Once we enter the main stream, we know we will
have no choice but to go with the current and travel down whichever fork it takes us. If we try to choose the
other fork, the current will be way too strong to paddle against, and we'd probably end up capsizing
.
So, what do we know about the market when the Psychometric Evaluators show us two green bars? We know
that a lot more shares are being traded (higher volume). We also know that the trades are favoring the direction
in which the current bar is moving, and we know that price movement is picking up speed (higher VRR).
Usually, but not quite always, the green-green combination is accompanied by a close in the upper third of the
price bar in an upward trend, and in the lower third of the price bar in a downward trend. Thus, if we enter the
market with two greens, our best immediate strategy would be to go with the flow. It would be disastrous for us
to trade against the direction of the current bar.

Figure 19c. The Psychometric Evaluators (Red-Red) with price chart (JNJ, 10/15/2001 - 3/07/2002)
 Red-Red
As we continue down the river, the current begins to force us toward a narrow branch that opens into a wide,
but shallow body of water. Posted near the entry to that branch are two red signs. What do we know about the
river at this point? We know that the riverbed is smooth and there is no grade, so the surface will be calm and
there will be very little current. Things are slowing way down.

In the market, when the Psychometric Evaluators show us two red bars, it means that fewer traders are entering
the market, and price movement is slowing down. This often happens near the end of an Elliot wave of some
lower time frame. For example, the price has been rising, but as traders loose interest and are no longer willing
to enter the market, there is a general slowing or even slight decline in price.

Figure 19d. The Psychometric Evaluators (Red-Green) with price chart (JNJ, 10/15/2001 - 3/07/2002)
 Red-Green
Back to the river. Up ahead we see a man-made channel with a gate. A red sign and a green sign stand nearby.
From the signs, we know that when the volume of water in the river is low, farmers in the area, sensing a
possible change in the weather, open the gate. They store water in anticipation of a drought, or run it off in
anticipation of rain. Because of the red-green combination, we know that this channel is narrow, just deep
enough to be over our heads, and uneven on the bottom.

Although the volume flowing through the channel is not high, the channel itself is capable of moving us along at
break-neck speed. Even though we would like to go in another direction, if the farmers open the gate, we will be
drawn into the channel's swift, rough current. Knowing this, we wear life jackets, helmets, and whatever other
safety equipment we may need.

How does all of this relate to the market? When the Psychometric Evaluators show us Red-Green, we know
that we have low volume, but high price facilitation. If this situation is not followed within the next two bars by an
increase in volume, we can be pretty sure there will be a temporary change in direction. If Red-Green is
followed within one or two bars by higher volume, then it is just a pause in the action before the market moves
in our direction again. Our "safety gear" is making sure we are using the Tripwire (red line) as our stop loss
point.

Figure 19e. The Psychometric Evaluators (Green-Red) with price chart (JNJ, 10/15/2001 - 3/07/2002)
Green-Red
As we continue down the river, we come into an area that is deep and narrow. On the bank we see a green sign
and a red sign. Our knowledge of the signs tells us that the riverbed is smooth with no grade. There is high
water volume, and the current is strong but slow-moving in comparison to Green-Green or Red-Green areas.
We also know that the river forks ahead, and each fork is gated. A battle over water rights is raging between
two neighboring towns, and each is trying to get as much of the river to flow down its fork as possible.
Depending on who is controlling the water flow, we'll either continue toward our destination, or we'll have to
prepare take a detour.

In the market, a Green-Red combination offers us the greatest potential for getting in on the beginning of a
trend. Almost all major price moves end with a Green-Red as one of the top/bottom three bars. Knowing this
can help us identify the beginning of a trend. However, while almost all trends end with Green-Red, not all
Green-Red combinations mark the end of a trend. Green-Reds appear quit often, and if they don't end a trend,
they let us know the current one will go on until the Psychometric Evaluators show us the next Green-Red
combination.

Green-Reds signify the last great battle between buyers (bulls) and sellers (bears). Buyers want the price to
rise, sellers want the price to fall. More and more traders are getting into the market, but there is less price
movement in relation to the volume coming in. In the river analogy, they're duking it out at the gates, and
whoever wins, that's the way the water will flow; in the market, that's the way the trend will go.

Review of the Psychometric Evaluators

The Psychometric Evaluators are a pair of histograms that depict the current day's volume and a ratio of the
current volume to the day's trading range. These graphs work together to give us a picture of the how the "mass
mind" has affected the day's trading.

Components

● The Volume Histogram compares the current day's volume to the previous day's volume.
❍ The current day's bar is green if it is higher than the previous day's bar.

❍ The current day's bar is red if it is lower than the previous day's bar.

❍ Differences in volume reflect the combined decisions of all the traders in the market.

● The Volume:Range Ratio Histogram (VRR) was developed by Bill Williams, and is a simple and
accurate measure of how well the market facilitates the movement of price through time.
❍ We use it to compare the current day's price facilitation with that of the previous day.

❍ If today's histogram bar is higher than yesterday's, it is green.

❍ If today's histogram bar is lower than yesterday's, it is red.

❍ An increase or decrease in VRR tells us how the market is reacting to changes in volume.

Combining the Volume and VRR Histograms

● When we combine the Volume and the VRR, we have a tool that gives us powerful insight into the mass
mind.
● There are four possible combinations, each of which tells us something about the underlying structure of
the market. They are our first clue as to what is in the collective minds of all traders in the market.
❍ The Green-Green combination means

■ More shares being traded (higher volume)

■ Trades are biased in the direction of the current bar's price direction

■ The market is moving the price efficiently through time (higher VRR)

■ We go with the flow

❍ The Red-Red combination means

■ Fewer shares are being traded (lower volume)

■ Price movement is slowing down (lower VRR)

❍ The Red-Green combination means

■ We have low volume, but high price facilitation

■ If the next two bars show no increase in volume, we will see a temporary change in price

direction.
■ If Red-Green is followed shortly by higher volume then it is just a pause in the action

before the market moves again.

❍ The Green-Red combination means

■ We have high volume and low price facilitation

■ We can identify the end of a trend (red-green is one of the three top (bottom) bars
 ■ We can approximate how much longer the trend will continue (at least until another green-
red combination)

References
Dalton, J. F., Jones, E. T., and Dalton, R. B. Mind over markets. Chicago, IL: Probus Publishing Co., 1990.
Kindelberger, C. P. Manias, panics and crashes. New York: Basic Books, 1978.
Lebon, G. The crowd. Deleware: Cherokee Publishing, 1982.
Smith, A. Powers of the mind. New York: Random House, 1975.
Steidlmayer, P. J., and Koy, K. Markets and market logic. Chicago: Porcupine Press, 1986.
Williams, B. Trading chaos: Applying expert techniques to maximize your profits. New York: John Wiley and
Sons, Inc., 1995.
Zweig, M. Winning on Wall Street. New York: Warner Books, 1990.

Module 8. The Accelerometer - The Early Warning Signal of Trend

Changes
In this module, you will gain an appreciation of how the Accelerometer alerts you to future changes in a
market's trend.

Up to this point, we have learned that before there is a change in trend, there must be a change in momentum,
and before momentum changes, there must be a change in the speed at which the market is traveling, and
before the speed changes, there must be a change in volume, and before volume changes, traders must make
decisions to buy, sell, enter, exit, or stay in the market.

In earlier chapters, we examined Chaos Theory and how it applies to trading stocks. We took a look at fractals
and fractal formations and saw how they relate to the underlying structure of the market. We went through a
detailed description of how the Gatekeeper, our principal decision-making tool, combines with the break-out
fractal to:

● keep us out of bad trades in a range-bound market,

● help us get into a trend early on,
● show us when to exit a trade,
● assist us in setting stop-loss points

The previous chapter gave us a glimpse into the workings of the mass mind. We learned that what begins as a
decision in the mind of an individual trader can, through an extremely complex series of unpredictably linked
events, lead to a change in trend. We also saw how the Psychometric Evaluators provide signs that give us
clues to the underlying structure of the market as it stretches before us.

We are now going to take a close look at the Accelerometer histogram. The formulas for calculating the
histogram bars are based on the actual closing price, and are derivatives of the formulas we use for the
Momentum Oscillator. This allows us to integrate the two tools for even more accuracy in our trading.

The Accelerometer is a leading indicator, and is extremely sensitive to changes in the acceleration or
deceleration of market momentum. It's a leading indicator in that it registers changes in direction before the
Momentum Oscillator does, and long before the trend changes. The bars on the Accelerator histogram are
colored red and green in the same way that the Volume and VRR histograms are. If the current bar (the bar
farthest to the right) is higher than the previous bar, it is green. If it is lower than the previous bar, it is red. A
change in color represents a change in speed, which makes it easy to spot acceleration or deceleration of
momentum.

Let's look at the principles of speed and momentum for a moment. If we fire a cannon ball at a 45° angle into
the air, energy expended by the exploding powder will propel it out of the muzzle at great speed. The ball's
weight and momentum will carry it upward, but with each passing foot, it will gradually decelerate until it
momentarily stops at the peek of its trajectory. Then it will begin to fall, gaining speed again as it travels
downward. If we look at this phenomenon from the standpoint of physics, we could say that at the moment the
ball began slowing down, it started accelerating in the opposite direction. The Accelerometer works along these
same lines. The cannon ball illustration below can help us visualize this phenomenon.
 Figure 20 gives us a look at the Accelerometer and how it relates to the price charts. The arrows originate at
the point where major changes in speed are taking place, and they end at the corresponding bar on the price
chart. By relating major changes in speed as registered on the Accelerometer histogram with price movement
reflected in the price chart, we get an early warning signal of possible trend changes.

Figure 20. The Accelerometer (JNJ, 11/08/2001 - 4/01/2002)

 The Accelerometer helps us in two ways. In area 1 above, it shows us where the speed of the price movement
has begun to slow in its downward movement (green bars below the zero line) and then accelerate in the
opposite direction (green bars above the zero line). Thus, we have an early warning of a possible change in
direction, because before market momentum changes, the speed at which price is traveling must change.

The second way in which the Accelerometer is useful is shown in area 2. As long as the Accelerometer's
histogram bars are above the zero line, we are seeing an early estimate of the overall effective length of a
particular price move. Later, you will see how we integrate the Accelerometer into the system.

Module 9. The Momentum Oscillator - Reading the Financial Pages of

Tomorrow's Newspaper Today
In this module, you will understand how the Momementum Oscillator shows the strength and direction
of the market's underlying momentum.

The Momentum Oscillator is a histogram that displays changes in the strength and direction of market
momentum. The formula we use to compute the comparison and create the histogram bars, though quite
simple, is based on fractal geometry and derivatives of Fibonacci ratios. Superimposed over the histogram is a
signal line that confirms a change in the momentum.

Understanding how the Momentum Oscillator works is like being able to read the financial pages of tomorrow's
newspaper. For example, if we wanted to, we could use it to trade any market profitably without ever looking at
a chart.

When the oscillator starts rising and the signal line separates from the histogram bars, we call our broker and
place an order to buy "at market." At market means whatever price the market is at when our order hits the
floor. We stay long the market until the oscillator begins to fall, and when the signal line separates from the
histogram bars, we call our broker and say, "Sell at market." Sounds impossible? Once you try it on a few
charts, you'll see that you can do fairly well. We don't recommend this approach because it is possible to be a
lot more accurate with our trading when we use all of The Fractal's Edge tools together.

Figure 21 shows an example of the Momentum Oscillator.

Figure 21. The Momentum Oscillator with Signal Line, JNJ, 11/2/2001 - 3/26/2002
As with the Psychometric Evaluators and the Accelerometer, Any histogram bar that is higher than the pervious
one is green, and any that is lower than the previous bar is red. This makes a change in momentum instantly
visible. When we see a change in color, we're seeing a change in the immediate momentum. When the signal
line detaches itself from the histogram bars, we are given an early warning of a shift in momentum. When the
histogram bars cross the zero line, we have a confirmation of the shift.

References
Bernstein, J. Timing signals in the futures market. Chicago, IL: Probus Publishing Co., 1991.
Davis, R. E. and Thiel, C. C. A computer analysis of moving average applied to commodity futures trading.
West Lafayette, IN: Ouiatenon Management Company, 1969.
Eckmann, J. P., and Rjuelle, D. Review of modern physics, 57, 3, 1985.
Kaufman, P. J. New commodity trading systems and methods. NY: John Wiley and Sons, 1987.
Korsan, R. J. Fractals and Time Series Analysis. Mathematics Journal, 3, 1993.
Priestly, M. B. Nonlinear and Nonstationary time series analysis. New York: Academic Press, 1988.
Tong, H. Nonlinear time series: A dynamical systems approach. New York: Oxford Science Publications, 1990.

Module 10. The E-Wave Oscillator - Confirmation That It's Time to

Exit the Market
In this module, you will see how the E-Wave Oscillator confirms that the momentum of a current trend
has turned.

The E-Wave oscillator is a precise indicator of overall, longer-range market rhythm. It measures the ebb and
flow of the market and shows where it begins to pick up or run out of steam. For example, when the signal line
is no longer touching the histogram bars of the E-wave oscillator, it is a leading indicator that the market is
running out of energy and possibly changing direction.

This is particularly true if the bars become shorter and shorter as they move toward the zero line. On the other
hand, when the signal line is cutting through the bars, it is an indicator of the strength and direction of the trend,
particularly if the histogram bars become progressively longer as they move away from the zero line. The
histogram bars themselves provide the confirmation of overall trend direction. If the bars are above the zero
line, the overall trend direction is upward, and if they are below the zero line, the overall trend direction is
 downward. When the signal line is cutting through the histogram bars, then market momentum is strong. Let's
look at Fig. 22, the E-Wave Oscillator without the price chart, and examine it for evidence of overall market
direction.

Figure 22. E-Wave Oscillator (JNJ, 11/20/2001 - 4/12/2002)

The dotted vertical arrows indicate separation of the signal bar from the histogram bars, with red representing
downward pressure or direction and green representing upward pressure or direction. The solid vertical arrows
indicate where the histogram bars cross the zero line and represent confirmation of major directional change.
The solid horizontal arrows show the extreme limits of directional movement. We do not want to be long the
market when the E-Wave histogram bars are below the zero line.

Module 11. Putting It All Together

Now it's time to see how we can use all of the indicators together to help us make more informed trading
decisions. We'll be integrating the indicators so that you can see how they function together. Assume that the
date is February 15, 2002, and we are looking for a set up to buy Johnson and Johnson (JNJ).

Fig. 23. JNJ, 9/27/2001 - 2/15/2002

 The E-Wave Oscillator

In Fig. 23 above , we begin with the price chart and the E-Wave Oscillator. We can see from the price chart that
the market has been trading in a channel pretty much between 55.00 and 60.00 for quite some time now. We
can also see that with today's price bar, the most recent buy fractal has just formed.

Examining area 1 of the E-Wave Oscillator, we note that the histogram bars are below zero, which means that
the current overall market direction appears to be downward. However, we see also that the signal line has
separated from the histogram bars, which are moving toward the zero line. This is an indication of upward
pressure and a possible change in market direction. Let's see if the Momentum Oscillator can provide any
additional information.

Figure 24. JNJ, 9/27/2001 - 2/15/2002

The Momentum Oscillator

Figure 24 area 2 shows how the E-Wave and Momentum Oscillator are integrated. The Momentum Oscillator is
a histogram that displays changes in the strength and direction of the more immediate, shorter-term market
momentum. As such it usually leads the E-Wave Oscillator by a few days. Like the E-Wave, the Momentum
Oscillator has a signal line, and when it separates from the histogram bars, it indicates a weakening of the
shorter-term momentum. The Momentum Oscillator gives warning of impending changes, and the E-Wave
confirms the warnings.

For example, if the Momentum signal line separates from the histogram bars, but the E-Wave signal line does
not, there is no confirmation of impending change. However, at the point at which both the E-Wave and the
Momentum Oscillator agree, then we have a strong confirmation of impending change (dotted green arrows).
Likewise, the Momentum Oscillator's histogram bars will cross the zero line in advance of the E-Wave's bars
crossing the zero line. At the moment, we have advance warning in that the Momentum Oscillator has crossed
the zero line, but no confirmation of change because the E-Wave has not yet crossed the zero line. Let's see
 what light the Accelerometer can shed on the situation.

Figure 25. JNJ, 9/27/2001 - 2/15/2002

The Accelerometer
The Accelerometer is a leading indicator, and is extremely sensitive to changes in the acceleration or
deceleration of market momentum. It's a leading indicator in that it registers changes in direction before the
Momentum Oscillator does, and long before the E-Wave crosses its zero line and the trend changes. The bars
on the Accelerator histogram are colored red and green in the same way that the Momentum histogram bars
are. If the current bar (the bar farthest to the right) is higher than the previous bar, it is green. If it is lower than
the previous bar, it is red. A change in color represents a change in speed, which makes it easy to spot
acceleration or deceleration of momentum.

We have learned that before there is a change in trend, there must be a change in the strength and direction of
long-term momentum (E-Wave). And before long-term momentum changes, there must be a change in the
strength and direction of short-term momentum (Momentum Oscillator). And before there is a change in the
strength and direction of short-term momentum, there must be a change in the speed at which the market is
traveling (Accelerometer). In trading stocks, we are only interested in whether the Accelerometer histogram
 bars are above the zero line or below it.

Figure 25 area 3 shows us that the Accelerometer crossed the zero line several days ago, giving us the earliest
warning of a change in direction. With the Accelerometer above the zero line, the Momentum Oscillator's
crossing the zero line (area 2), and with the E-Wave Oscillator's signal line separated from the histogram bars,
we have strong confirmation of a change in direction and an opportunity to buy. Before placing an order, let's
see what's been going on in the mass mind by taking a look at the Psychometric Evaluators.

Figure 25b. JNJ, 9/27/2001 - 2/15/2002

 When you make a decision to buy, sell, enter, or exit, or stay, that decision is combined with the decisions of all
the other traders in the market. Remember that the first effect in the chain of events leading to a change in
market direction is the cumulative effect of all those decisions. This cumulative effect shows up as orders going
to the floor, which, in turn, translates into volume of shares traded (Volume) and the impact of volume on the
range of price movement (VRR). Thus, the Psychometric Evaluators (PE) give us some indication of what is
going on in the mass mind.

Figure 25b area 4 shows us that on March 12 and 13, there was an increase in volume (Green), but lower price
facilitation relative to the volume (Red) for each day. The Green-Red combination indicates a storing of energy,
and is our strongest forewarning of price change. Note that the fractal bar is a Green-Red bar. The important
thing to note is that there has been a recent change in volume, an indication that a possible major price change
is in the making.

Today, however, is March 15, and PE is showing Red-Green. When the Psychometric Evaluators show us Red-
Green, we know that we have low volume for the day, but high price facilitation. If this situation is not followed
within the next two bars by an increase in volume, we can be pretty sure we are experiencing a temporary
change in direction. If Red-Green is followed within one or two bars by higher volume, then it is just a pause in
the action before the market continues its current direction.

Let's recap the information we have gleaned from our analysis of the indicators in Figure 25b:

● We have experienced a recent increase in volume (area 4)

● The Accelerometer is above the zero line (area 3).
● The Momentum Oscillator's signal line has separated from the bars and momentum is accelerating
upward toward the zero line (area 2).
● The E-Wave Oscillator's signal line has separated from the bars and the bars are moving upward toward
the zero line (area 1).
● We have a valid buy fractal (the low of the fractal bar is above the nearest Stability Line).

The above factors present us with strong confirmation of an opportunity to buy, so let's see how that is done.

Based on our initial analysis, we do the following:

1. Determine our buy line by taking the value of the fractal bar (Feb 13), which has a high of 58.89. Add
two cents to the price and for a buy line of 58.91.
2. Set our initial stop loss at the value of the lowest stability line. Looking at the Indicators and Values table
to the right of the price chart, we see that the Tripwire has the lowest price at 56.80.
3. We call our broker and instruct him to buy 100 shares of CCE at 58.91, with a stop loss at 56.80.
4. Follow the progress of the market.

It is now time to see how things have developed over the last few days. Let's take a look at Figure 26.

Figure 26. JNJ, 10/4/2001 - 2/21/2002

 It is now Feb. 21, and today's high of 58.95 crossed our buy line of 58.91 (blue line on price chart), so our buy
order has been filled. The E-Wave has crossed the zero line (area 1), and the signal line is cutting deep into the
current histogram bar-an indication of a very strong upward price movement. The Momentum Oscillator is
above the zero line (area 2) and its signal line is cutting through the current histogram bar, adding support to the
probability that price is moving upward. The Accelerometer is above the zero line and green, indicating that
price is accelerating upward.

Finally, the PE is showing increased volume, and we are currently sitting on a Green-Red combination,
indicating the existence of a great deal of stored energy. The market will most likely (but not always) continue in
its current direction at least until another Green-Red shows up.

Based on the current analysis, we do the following:

1. Set our stop loss. Since the trade is still young, we will need some maneuvering room, so we'll use the
value of the Stability Line that is furthest away from the low of today's bar. In this case, it happens to be
the Wall at 57.09.
2. Call our broker and have him set the stop loss.
3. Continue to observe the market through the indicators.

It is now March 8, eleven days after entry (see Fig. 27).

Figure 27. JNJ, 10/22/2001 - 3/8/2002

We have moved our stop loss to the Tripwire (red Stability Line), changing it daily until, on March 1, the stop
loss brought us above break even at 59.26. We have held it there (Figure 27, yellow horizontal line on price
chart), waiting for a warning of change in direction. As a more conservative approach, we could have continued
"trailing" our stop loss along the Tripwire, changing the stop loss daily as the value of the Tripwire changed. As
a highly conservative strategy, we could have trailed our stop along the Fence. It's really a matter of money
management strategy, risk tolerance, and individual trading style.

The Stability Lines on the price chart in Figure 27 are all separated, indicating that the gate is open. In area 1,
the E-Wave is above zero and the signal line continues to cut through the histogram bars, indicating strength in
the market's overall upward direction. Area 2 on the Momentum Oscillator shows the signal line cutting through
the histogram bars as additional evidence of strong upward price movement.

In addition, area 3 on the Accelerometer shows the histogram bars to be above the zero line, indicating that the
upward direction is still solid. We note, however, that the Accelerometer is indicating a slow-down in the speed
at which the price is moving. For now, we'll watch the Accelerometer closely to see if it moves below the zero
line, an early warning of change.

In area 4, the PE shows us that on March 7 (yesterday) we had a Green-Red combination. At this stage in the
upward move it could be telling us that the trend will continue until at least the next Green-Red, or that this is
the Green-Red that signals the end of the trend. Today's Red-Green combination signifies either a pause in the
action, or the beginning of a slight downward move. We'll watch the PE as well for early warning of change.

Based on today's analysis, we do the following:

1. Determine our stop loss point (i.e., keep it at 59.26, "trail" the Tripwire, or "trail" the Fence) and inform
our broker.
2. Continue to observe the market through the indicators.
 It is now March 13, sixteen days after entry (see Fig. 28).

Figure 28. JNJ, 10/26/2001 - 3/13/2002

 To begin with, in Figure 28, area 5, we see that yesterday (March 12), the PE showed a Green-Red
combination, a signal that the trend is either ending or will continue until the next Green-Red. Today's (March
13) Red-Green combination signifies either a pause in the action, or the beginning of a slight downward move.
We'll need to wait a day or two to see. Meanwhile, in area 4, we see that the Accelerometer has crossed the
zero line. This is an early warning that a change may be in the wind. Coupling that with the PE's Red-Green
today, we put on our safety gear and adjust our stop loss to protect our gains by moving it to the Tripwire's
value for the current bar-62.74 (see Figure 28, price chart area 1).

Adding weight to the possibility of change is the fact that the Momentum Oscillator's signal line has separated
from the histogram bars (area 3).

However, the E-Wave Oscillator's signal line is still touching the current histogram bar, indicating that the overall
market direction is still upward (area 2).

Based on today's analysis, we do the following:

1. Inform our broker of the new stop loss point.

2. Continue to observe the market through the indicators.

It is now March 15, eighteen days after entry (see Fig. 29).

Figure 29. JNJ, 10/29/2001 - 3/15/2002

 In Figure 29, again beginning with area 5, we note that the PE is presenting us with another Green-Red
combination. When we add this to the fact that the Accelerometer is still below the zero line, we pick up a strong
warning that even though the price appears to be rising, a change may be in the wind. Providing further
evidence of the possibility of change, the Momentum Oscillator's signal line remains separated from the
histogram bars (area 3). This is an indication that momentum may be slowing.

In addition, yesterday's E-Wave signal line separated from its bar (red arrow in area 2). Therefore, we adjusted
our stop loss to further protect our gains by moving it to the low of yesterday's price bar-63.70 (see price chart
area 1). However, the E-Wave Oscillator's signal line is still touching the current histogram bar, indicating that
the overall market direction is still upward (area 2).

Based on today's analysis, we do the following:

1) Inform our broker of the new stop loss point.

2) Continue to observe the market through the indicators.

It is now April 11, and the trade has concluded. Fig. 30 shows us how it played out.

Figure 30. JNJ, 11/21/2001 - 4/11/2002

 We left off on Friday, Mar. 15. On Monday, Mar. 18, we find the PE presenting Red-Green (area 5), the
Accelerometer still below the zero line (area 4), and the Momentum Oscillator's signal line still separated from
the histogram bars (area 3). With volume thinning out, the upward speed of price slowing quickly, and
momentum weakening, we need to prepare to exit.

In addition, the E-Wave's signal line has again separated from the histogram bars (violet arrow from area 2 to
area 1), so at the end of the day on March 18, we moved the stop loss to the low of the price bar (Mar 18) at
64.30 (violet arrow from area 2 to area 1). On Mar 21, after twenty-one days in the market, our stop loss is hit
on the open (64.30), and we are out of this trade. Our profit = (64.30 - 58.91)*100 = $539.

Module 12. Quick Reference Guide

This chapter reviews the procedures to follow when using The Fractal's Edge For Stocks, and can be used as
a quick reference guide.

A. What to look for when seeking trading opportunities (Fig. 31):

1. A long, narrowly traded channel (not always necessary, but channels present the greatest
opportunities).
2. E-Wave histogram bars below the zero line, with separation of E-Wave signal line from histogram bars.
3. Momentum Oscillator histogram bars below the zero line, with separation of Momentum Oscillator signal
line from histogram bars. Best if Momentum Oscillator is just crossing zero line.
4. Accelerometer crossing the zero line.
5. Fractal bar in the area, with low above the nearest Stability Line.

Figure 31. JNJ, 9/27/2001 - 2/15/2002

 B. What to do and look for when entering, maintaining, and exiting a trade Figure 32:

1. Set a "buy line" two points above the high of the fractal bar
2. Establish initial stop loss point at value of the Stability Line that is furthest from the low of the fractal bar.
3. Enter market when price crosses buy line.
4. After buy order is filled, "trail" the stop loss point along either the blue or red Stability Line until break-
even point is reached, then hold stop loss at break even point.
5. Move stop loss to value of Fence if Accelerometer goes below zero line.
6. If E-Wave signal line separates from histogram bars, move stop loss to low of corresponding price bar.
7. Exit market when price falls below stop loss line.

Figure 32. JNJ, 11/21/2001 - 4/11/2002

How to Use TFE to Profit from Down-Trends

In this edition, we'll focus on how to trade downtrends in the stock market, an area we mentioned only in passing in the online
course. While shorting the market uses the same principles as trading long, the difference in procedure lies in the fact that
prices are falling instead of rising. The main reason that we focused only on opportunities to go long the market is that even
though it is possible to enter short positions, there are some restrictions.

These restrictions are not insurmountable but do involve:

1. shorting only shares valued above $5.00,

2. borrowing shares,
3. maintaining a higher margin (60% or more) based on perceived risk, and
4. having to wait for an order to be valid only after an up tick or a "zero plus" tick occurs, to name a few.

Although we can show you how to use TFE to determine entry and exit points for selling stocks short, for further advice on
shorting the market, contact your broker. After you have familiarized yourself with the risks and restrictions involved in short
selling, you can follow the procedures outlined below.

THE FOLLOWING ANALYSIS IS FOR INSTRUCTIONAL PURPOSES ONLY AND DOES NOT REPRESENT ADVICE OR
SOLICITATION TO BUY, SELL, HOLD, OR REFRAIN FROM BUYING OR SELLING THE SUBJECT SECURITY.

This is the setup to look for when screening stocks for possible candidates to trade during downtrends. For the purposes of
this module of instruction, we'll assume that the date is 01/05/05.

A) E-wave above zero line and signal line separating from histogram bars.
B) Momentum moving downward from above zero line and about to cross or just crossing zero line from above. Momentum
signal line separated from histogram bars.
C) Accelerometer crossing zero line from above.
D) Valid fractal in the area. Notice that fractal bars 1 and 2 are invalid because their highs are above the stability lines. Fractal
3 (10/28/04), however, is clear of all stability lines. The fractal bar has a low of 16.78, so we would place our preliminary entry
order to sell at 16.76. NOTE: Since this fractal is quite distant from the current date, it is possible that a more recent one will
form. We would also set our stop loss at the stability line furthest away from the high of the current bar, which is the Tripwire
(red line) at 18.45. Now we're set to go.

Illustration 1. Preliminary fractal setup. SSCC 9/29/04 - 01/05/05

With a preliminary sell line in place, we're set to watch the market and see how this trade unfolds. Let's take a look at the next
couple of days:

Illustration 2. New fractal formed. SSCC 10/04/04 - 01/11/05

A) The 1/07 bar, a new fractal bar with a high of 17.41, provides a new entry point at 17.39. Along with the new fractal sell line,
we set a new stop loss point at the Wall (blue stability line--18.26) because it is the line that is farthest away from the high of
the current bar.
B) The E-Wave has crossed the zero line, and its signal line is cutting into the histogram bars, confirming that the current
overall direction of the market is downward.
C) Momentum has crossed the zero line and its signal line is cutting into the histogram bars, indicating that the current overall
direction of the market is downward. However, the last two histogram bars are green, indicating a weakening momentum.
D) The Accelerometer is below zero, but its last two bars are green, indicating that momentum is slowing.

At this time, we have a new entry point of 17.39 and a new stop loss of 18.26.

We're still watching to see what develops, so let's go on to Illustration 3 for a look at what the next few days bring:

Illustration 3. Entry price "hit". SSCC 10/06/04 - 01/13/05

A) In Illustration 3, it is now 1/13/05 and our entry price (17.39) has been hit. Because it is important in the early days of a
trade to allow some room for maneuvering, we are using the Wall (blue stability line) as the stop loss point. We will "trail" the
stop along the Wall until we hit our breakeven point. Our stop for the next day is set at 18.13.
B) The E-Wave is below the zero line, and its signal line is cutting through the histogram bars, confirming that the current
overall direction of the market is still downward.
C) Momentum, which had been slowing, is picking up steam. The histogram bars are below zero, indicating that the market is
moving downward. However, with the signal line separated from the current histogram bar, the movement is not as strong as it
could be.
D) The Accelerometer is above zero, indicating that the speed at which price is moving has been slowing. Today's red bar
indicates an increase in speed.

With our stop loss set at 18.13, we're ready for the next day. So let's turn our attention to Illustration 4 to see how the trade
has progressed over the next several days.

Illustration 4. SSCC 10/12/04 - 01/20/05

A) In Illustration 4, it is now 1/20/05 and our trailing stop loss is approaching our breakeven point (17.39). We will continue to
"trail" the stop along the Wall until we hit our breakeven point. Our stop for the next day is set at 17.75.
B) The E-Wave is still below the zero line, with its signal line cutting through the histogram bars. This confirms that the current
overall direction of the market is continuing downward.
C) Momentum has continued to pick up steam. The histogram bars are below zero, indicating that the market is moving
downward. The signal line cutting through the histogram bars signifies strong momentum.
D) The Accelerometer is back below zero, indicating that the speed at which price is moving has been increasing. However,
today's green bar indicates a slight decrease in the speed of price change.

With our stop loss set at 17.75, we're ready for the next day. We'll now go to Illustration 5 to see how the trade has progressed
over the next several days.

Illustration 5. Crossing Breakeven point. SSCC 10/15/04 - 01/25/05

A) In Illustration 5, it is now 1/25/05, and at 17.22, our trailing stop loss has crossed our breakeven point of 17.39. We will hold
the stop at 17.22 until we get feedback from Momentum and Accelerometer. Our stop for the next day is set at 17.22.
B) The E-Wave is still below the zero line, with its signal line cutting through the histogram bars. This confirms that the current
overall direction of the market is continuing downward.
C) Momentum has continued to pick up steam. The histogram bars are below zero, indicating that the market is moving
downward. The signal line cutting through the histogram bars signifies strong momentum.
D) The Accelerometer is also below zero, indicating that the speed at which price is moving has been increasing. Moreover,
today's longer red bar indicates a significant increase in the speed of price change.

With our stop loss set at 17.22, we're ready for the next day. We'll now go to Illustration 6 to see how the trade has progressed
up to the present.

Illustration 6. Tightening stops. SSCC 10/25/04 - 02/01/05

A) In Illustration 6, it is now 2/01/05. On 1/25/05, we left our stop loss at 17.22 until feedback from Momentum and
Accelerometer informed us otherwise.
B) The E-Wave is still below the zero line, with its signal line cutting through the histogram bars. This confirms that although
Momentum and Accelerometer are indicating change, the current overall direction of the market is continuing downward.
C) Momentum continued to pick up steam until 1/28/05, when the histogram bars turned green. Although the histogram bars
are below zero, indicating that the market is moving downward, on 2/01/05, the signal line separated from the histogram bars.
This is warning that momentum is weakening.
D) The Accelerometer crossed the zero line on 2/01/05, indicating that the speed at which price is moving has been steadily
decreasing.

With Momentum turning green on 1/28/05, and Accelerometer also green, we move the stop along the Wall to 16.72. With the
same conditions prevailing on 1/31/05, we again move the stop along the Wall to 16.57.

On 2/01/05, Momentum signal line separates from bars and Accelerometer crosses zero from below. It is time to anticipate
exiting the trade. With Accelerometer above zero and Momentum weakening, we choose the Tripwire as the stop loss point at
15.80. If we wanted to be utraconservative, we could use the Fence as the stop loss point at 15.26.

This trade, which began on 1/13/05 at 17.39, has made $1.84 per share as of the close on 2/01/05 at 15.55.

The data presented here are for informational and study purposes only, and are not recommendations to enter, to buy, to sell,
or to take any position with respect to the markets referenced in this newsletter. Any action taken in the markets as a result of
this information is solely the responsibility of the reader, and such action should be done in concert with a licensed broker,
dealer, or advisor. Trading stocks involves a great deal of risk, and may not be for everyone.

HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN

ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE
THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER- OR- OVER-
COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY.
SIMULATED TRADING PROGRAMS IN GENERAL ARE SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE
BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO
ACHIEVE THE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. NFA-REQUIRED DISCLOSURE.

Congratulations on finishing The Fractal's Edge Stock Trading Method. If you are the type of trader that
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To your success!

Ken Herbert

Quantum Futures
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