Apply the Chaos Theory to Trading


Chaos Theory is defined as a branch of mathematics focused on the behavior of dynamical systems that are highly sensitive to initial conditions.  It refers to what seems to be lack of order, or chaos, in a system that has rules and laws. The Forex Market can certainly be a system that appears chaotic but follows rules and laws, so it is not completely surprising that there are experts who have looked to apply the Chaos Theory to Forex trading.   The first expert to discuss applying this theory to Forex trading was a Forex trader named Bill Williams.  Williams came up with a strategy using these ideas.

Bill Williams believed that the market behaves in a chaotic manner, and because of this, he did not believe technical analysis was the best way to approach Forex trading.  His strategy is based on the idea that the market has five dimensions and when you examine each one, you will have a much clearer picture of the market.  This will then guide you towards better decisions.

The five dimensions as Bill Williams explained them are:

  • Fractal – Trades should not be made before the first curve or fractal appears, which means five consecutive bars, in which the middle bar is the highest for buying or lowest for selling. He suggests that any signals from other dimensions can be disregarded initially.
  • Momentum – The Awesome Oscillator illustrates the current market momentum of the last five bars. They are compared with the previous 34.
  • Acceleration / Deceleration – This dimension measures the acceleration and deceleration of the market momentum, by looking at the momentum and the five-bar moving average.
  • Zone – The fourth dimension is known as the zone, and appears when the momentum and acceleration (or deceleration) are of the same direction.
  • Balance Line – The last dimension of the market is the balance line, which is the level at which the price would be if chaos was not influencing the market. This ‘chaos’ is any kind of information that might be hitting the markets. It is also described with the Awesome Oscillator. The idea is that it requires less energy for the price to move away from this line

Williams’ theory is extremely sensitive to price movements which suggests that using it can lead to profits even at the end of a trend.

There is a large camp of non-believers in Williams’ system.  Many who believe his system although it claims to be based on Chaos Theory is really based much more on Zen and market behavior.  Some also think that Bill Williams claims that technical analysis is not useful but then actually uses technical indicators to make his trading decisions. They believe that his dimensions are actually renamed versions of technical indicators that traders use regularly.   More research and studying of Williams’ work can help you determine to which camp you belong.

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