USE OF FRACTALS TO BUILD A PORTFOLIO, MEASURE RISKS AND ENHANCE TECHNICAL ANALYSIS

IN THE FINANCIAL MARKETS:

With respect to markets, advocates of this theory claim that stock prices move in fractals. They use
this as the basis for a form of technical analysis. In the same way that the patterns of fractals
repeat themselves along all time frames, stock prices also appear to move in replicating geometric
patterns through time.

This analysis focuses on the price movements of assets based on the belief that the history of
stock prices repeats itself at different scales. Following this framework, the FMH (Fractal Market
Hypothesis) studies investor horizons, the role of liquidity, and the impact of information through
the business cycle.

Perhaps the most glaring problem with quantifying and utilizing the FMH is deciding the length of
time that the “fractal” pattern should be repeated in trying to project market direction. A pattern
could be repeated on a daily, weekly, monthly, or even longer basis. But since fractals are
inherently recursive in an infinite cycle, a trader may not know when to start or at which scale to
operate.

It is, therefore, extremely difficult to accurately project the time period of repetition, despite it
likely being closely related to the investment horizon. It is also worth noting that the pattern
would likely not be identically repeated.

'Father of Fractals' takes on the stock market. Seeing a snowflake pattern in the NASDAQ.

Benoit Mandelbrot is world-famous for making mathematical sense of irregular shapes--clouds

that are not round, mountains that are not cones, coastlines that are not smooth, and now, stock
markets that are not as simple as previously thought.

Mandelbrot, known as the "father of fractal geometry," spoke Nov. 8 2006 to a crowd of more
than 200 people in Room 10-250 at MIT. His talk was the first in a series sponsored by the MIT
Molecular Frontiers Club. Molecular Frontiers is a new international alliance of scientists, including
several at MIT, intended to inspire young people to get involved in science. The title of
Mandelbrot's lecture was "The Mandelbrot Set and Fractals in Finance."

Mandelbrot coined the term "fractals" in 1975 to describe shapes that appear similar at all levels
of magnification and are also called "infinitely complex." Examples of fractal-like structures in
nature include snowflakes, rivers, broccoli flowers and systems of blood vessels.

"Fractals and chaos theory are particularly good at engaging young minds because of the images
involved," said Andreas Mershin, a postdoctoral associate at MIT's Center for Biomedical
Engineering, who introduced the 86-year-old Mandelbrot, who is the Sterling Professor of
Mathematical Sciences, Emeritus at Yale University and lives in Scarsdale, N.Y.
Mandelbrot, who sometimes drifted into anecdotes about former colleagues and students,
described the long process of his work. "I have been working on this subject all my life. My Ph.D.
was finished in 1952, and I never realized until recently what I was actually doing. Only later did I
realize that everything I was working on had the property of roughness."

In the middle of World War II, Mandelbrot was a young man studying in the south of France. "The
conditions were as grim as possible, and somehow I found I had this gift for seeing shapes in
complicated structures instantly," he said. After continuing his studies in Paris, Mandelbrot left
France for Caltech in 1947 to study aeronautics.

He returned to France to get a Ph.D. in mathematical sciences from the University of Paris and
then worked in the United States and Europe throughout the 1950s. In 1958, Mandelbrot settled
with his wife, Aliette, in Yorktown, N.Y., where he joined the research staff at the IBM Thomas J.
Watson Research Center. He went on to devote his academic life to seeing the truth in the
roughness of geometrical shapes.

After working on the general properties of fractals, he moved on to examine more specific and
complex examples, focusing on what came to be known as the Mandelbrot Set. An unusual type of
fractal that comes from a simple equation, the Mandelbrot Set is popular outside of mathematics
because of its aesthetic appeal and its complicated structure. No one has been able to prove the
Mandelbrot Set is true, according to Mandelbrot. "But no one has been able to prove it's not true,
either," he said, as large pictures of fractals filled the screen behind him.

Mandelbrot recently began to apply his knowledge of fractals to explain stock markets. "Markets,
like oceans, have turbulence," he said. "Some days the change in markets is very small, and some
days it moves in a huge leap. Only fractals can explain this kind of random change". He and a
journalist, Richard Hudson, have co-written a book on the thorny subject to explain the complex
gyrations of stock prices and exchange rates.

PAPER

A simple quantitative measure of the self-similarity in time-series in general and in the stock
market in particular is the scaling behavior of the absolute size of the jumps across lags of a certain
size. A stronger form of self-similarity entails that not only this mean absolute value, but also the
full distributions of lag jumps have a scaling behavior characterized by the Hurst exponent.

In 1963, Benoit Mandelbrot showed that cotton prices have such a strong form of (distributional)
self-similarity, and for the first time introduced Lévy’s stable random variables in the modeling of
price records.

The Hurst exponent (H) emerged from fractal geometry as a means to detect long-term
dependencies in a time series.

Tests suggest that the fractal nature of a time series explains a significant portion of the profits
generated by technical analysis.
How Fractals Can Explain What's Wrong with Wall Street

The geometry that describes the shape of coastlines and the patterns of galaxies also elucidates
how stock prices soar and plummet

If the weather is moderate 95 percent of the time, can the mariner afford to ignore the possibility
of a typhoon?

A substantial number of sudden large changes—spikes on the chart that shoot up and down —
stand out from the background of more moderate perturbations. The magnitude of price
movements (both large and small) may remain roughly constant for a year, and then suddenly the
variability may increase for an extended period. Big price jumps become more common as the
turbulence of the market grows—clusters of them appear on the chart.

Fractals do not purport to predict the future with certainty. But they do create a more realistic
picture of market risks.

A fractal is a geometric shape that can be separated into parts, each of which is a reduced-scale
version of the whole. Movements of a stock or currency all look alike when a market chart is
enlarged or reduced so that it fits the same time and price scale. An observer then cannot tell
which of the data concern prices that change from week to week, day to day or hour to hour. This
quality defines the charts as fractal curves and makes available many powerful tools of
mathematical and computer analysis.

A more specific technical term for the resemblance between the parts and the whole is self-
affinity. This property is related to the better-known concept of fractals called selfsimilarity.

What the Father of Fractals Can Teach Us About Finance

In The (Mis)Behavior of Markets, Benoit Mandelbrot offers a method to apply the process in
modeling the motion of financial securities including currencies, commodities, and stocks. He calls
this model the Multifractal Model of Asset Returns which provides a more realistic model for the
unpredictable nature of a human-driven market.

Mandelbrot explains that traders intuitively understand that time in financial markets is relative:
the first 15 minutes or the last 15 minutes of a given day’s market hours are generally more
volatile, and on larger scales, days and weeks may seem this way. In fact, professional traders
often speak of “fast” or “slow” markets. Due to this, he postulated the existence of “trading time”
distinct from clock/calendar time.

Transforming clock time to “trading time.”

A model for stock movements that accounts for the clustering of volatility and is flexible for
different lengths of time.
We can use these models to calculate risk when managing portfolios, price derivatives like options,
and to better understand how markets function as it can give us insight into human behavior.

Modeling Markets with Fractals

“A fractal is a pattern or shape whose parts echo the whole. Its power comes from its unique
ability to express a great deal of complicated, irregular data in a few simple formulae.” A fractal
begins with a classical geometric object such as a line or triangle — called the initiator. From here,
it repeats an iterative process that expands its complexity.

During times of high volatility, time speeds up. As prices become more stable, time slows. Then
there are the jumps. A price can teleport from one level to another without warning.

Mandelbrot studied hundred-year-old cotton prices all the way up to modern derivatives.
Concluding that all markets behave similarly to fluids.

Researchers began believing the tales of sailors, often reporting giant waves that defy oceanic
forecasting. In the first half of the 21st century over 500 ships were destroyed due to the
occurrence, making it more common than originally believed.

Much of the time prices move slowly, going up or down by small increments. However, with little
to no apparent reasoning, they shift into a state of large upheaval.

“Markets are turbulent, deceptive, prone to bubbles, infested by false trends”, writes Mandelbrot.

A FOCUS ON THE EXCEPTIONS THAT PROVE THE RULE

Book sales: line up a collection of 1,000 authors. Then, add the most read person alive, JK Rowling,
the author of the Harry Potter series with sales of several hundred million books. She would dwarf
the remaining 1,000 authors who would collectively have only a few hundred thousand readers.
So, while weight, height and calorie consumption are Gaussian, wealth is not. Nor are income,
market returns, size of hedge funds, returns in the financial markets, number of deaths in wars or
casualties in terrorist attacks. Almost all man-made variables are wild. Furthermore, physical
science continues to discover more and more examples of wild uncertainty, such as the intensity
of earthquakes, hurricanes or tsunamis.

Economic life displays numerous examples of wild uncertainty. For example, during the 1920s, the
German currency moved from three to a dollar to 4bn to the dollar in a few years. And veteran
currency traders still remember when, as late as the 1990s, short term interest rates jumped by
several thousand per cent.

Taken together, these facts should be enough to demonstrate that it is the so called “outlier” and
not the regular that we need to model. For instance, a very small number of days accounts for the
bulk of the stock market changes: just ten trading days represent 63% of the returns of the past 50
years.
Projections of deficits, performance and interest rates are marred with extraordinarily large errors.
In many budget calculations, US interest rates were projected to be 5% for 2001 (not 1 per cent).
Oil prices were projected to be close to $22 a barrel for 2006 (not $62). Like prices, forecast errors
follow a fractal distribution.

You are far less diversified than you assume. Because the market returns in the very long run will
be dominated by a small number of investments, you need to mitigate the risk of missing these
by investing as broadly as possible. Very broad passive indexing is far more effective than active
selection.

Markets keep in memory the volatility of past deviations. A subtle concept, fractal memory
provides an intrinsic way of modelling both the clustering of large events and the phenomenon of
regime switching, which refers to phases when markets move from low to high volatility.

Inside The Incredible World of Fractals, the Beautiful Patterns That Investors Use To Analyze
Charts

Fractals can also be used in technical analysis when trading, often in conjunction with a pattern
like the Alligator indicator or Fibonacci retracements. Fractals are simply broken up pieces of a
larger movement, most frequently constructed visually as a bar chart.

Fractals present an easy way to remove some risk as you follow greater trends in a security's move
up or down. When a fractal shifts direction, it's a quick indication to get out of your position.

The theorem itself was created by Gottfried Leibniz, a mathematician and philosopher. Years later
other mathematicians would advance the theory, but it was not until 1975 when Benoît
Mandelbrot gave the term fractal its name.

Building a Better Fund of Hedge Funds: a Fractal and α - Stable Distribution Approach

The Hurst Exponent

The Hurst exponent occurs in many areas such as fractals and chaos and has recently made its way
into the world of finance. It is a summary statistic of persistence that has been used to
characterize long memory processes in time series.

The idea of this statistic originates with Hurst (1900 – 1978) who was an English hydrologist who
worked on the Nile River Dam project. While designing a dam, he was concerned about adapting
the dam’s storage capacity to accommodate changes that may occur in the rivers water level.

He studied an 847-record of the Nile River’s overflows and found that flood occurrences could be
characterized as persistent, i.e. heavier floods were followed by above average flood occurrences,
while below average occurrences were followed by minor floods.

Through this process he developed what has become known as Rescaled Range (R/S).
HURST EXPONENT WIKIPEDIA

In fractal geometry, the generalized Hurst exponent is directly related to fractal dimension, D, and
is a measure of a data series' "mild" or "wild" randomness.

The Hurst exponent is referred to as the "index of dependence" or "index of long-range

dependence". It quantifies the relative tendency of a time series either to regress strongly to the
mean or to cluster in a direction.

A value H in the range 0.5–1 indicates a time series with long-term positive autocorrelation,
meaning both that a high value in the series will probably be followed by another high value and
that the values a long time into the future will also tend to be high.

A value in the range 0 – 0.5 indicates a time series with long-term switching between high and low
values in adjacent pairs, meaning that a single high value will probably be followed by a low value
and that the value after that will tend to be high, with this tendency to switch between high and
low values lasting a long time into the future.

A value of H=0.5 can indicate a completely uncorrelated series, but in fact it is the value applicable
to series for which the autocorrelations at small time lags can be positive or negative but where
the absolute values of the autocorrelations decay exponentially quickly to zero.

This in contrast to the typically power law decay for the 0.5 < H < 1 and 0 < H < 0.5 cases.