Parabolic Stop and Reverse: The Other Way of Stopping

09/06/00 10:44:25 AM

by David Penn

A creation of the futures markets, the parabolic stop and reverse helps traders get out (or in) while the getting is good.

Security: AMZN
Position: N/A

Of the many challenges that technically-oriented analysts face, setting appropriate stops and finding the "sweet spots" in trends (points where a trend is about to change direction from bullish to bearish or vice versa) are among the most trying--and the most rewarding. The placement of an effective stop can make the difference between a quick, relatively painless loss and an ego-bruising plunge. And being able to find out where a particular trend has exhausted itself could be the prelude to catching a ride on a bull market from almost the very beginning. While many indicators and oscillators can help traders respond to either challenge, one indicator, the parabolic stop and reverse (also known as parabolic SAR or the parabolic system) goes a long way toward solving both the problems of stop placement and trend reversal.

The parabolic SAR was developed by J. Welles Wilder, Jr., the same technical analyst who brought us the relative strength index (RSI). With the parabolic SAR, traders use recent extremes in price and an "acceleration factor" to determine a series of points that form a parabola beneath uptrends and above downtrends. These points can then be used as effective stop-loss points for trading. As the trend begins to lose momentum, the trend eventually intersects with the parabolic SAR and it is at this intersection point that a potential trend reversal is signaled. Here, a new parabola begins to appear on the opposite side of the price action, indicating that the trend has, in fact, reversed. In this way, the action of the parabolic SAR is similar to the action of a line of support turning into a line of resistance when price action indicates a reversal in trend. Below is the formula for determining parabolic SAR in the absence of computer charting software that performs the calculations automatically.

SAR current = SAR previous + AF x (EP - SAR previous)

-- SAR previous is the value of SAR one period ago
-- AF is the "acceleration factor", which starts at 0.02 and increases by 0.02 each time a new price extreme is noted, up to a maximum factor of 0.2
-- EP is the extreme price, the highest high in the previous advance if during a downtrend, the lowest low in the previous decline if during an uptrend

Figure 1: Daily chart for Amazon.com plotted with the Parabolic SAR indicator.

Graphic provided by: MetaStock.

The daily chart of Amazon.com (AMZN) is a good example of how the parabolic SAR appears against price action. Note that on July 26, a new parabola appeared above the price, indicating a downtrend was in effect. The price action for AMZN intersected the parabola on August 14, an intersection that is referred to as a stop-reversal point and signified the likely change in trend. Additionally, a new parabola appeared beneath the price action. As this new parabola continued upward, it acted as confirmation of the trend reversal. The parabolic SAR indicated going short on July 26, when AMZN closed at 36 (AMZN went on to lose another eight points). A long signal was made on August 15, when AMZN closed just shy of 38 (AMZN went on to gain another six points by August 30).

The short/long signals in the Amazon example do not represent the largest point swings possible using parabolic SAR, but the example provides a fairly clear picture of how parabolic SAR works. Remember that parabolic SAR is both a trend-following (or even trend-reversal following) indicator as well as an aid in placing stops, and is often even more effective when used with an indicator such as directional movement. Directional movement, briefly, is a measurement of buying and selling pressure, with a bullish reading being given when the DI+ (plus) line is above the DI- (minus) line, and a bearish reading when the DI- line is above the DI+ line. These readings are particularly strong during crossovers (i.e., when the DI+ line has been below the DI- line for a period of time and then begins to rise above it), but often these crossovers are short-lived. In such cases, parabolic SAR can help confirm the validity of bullish or bearish signals from the directional movement indicators. From August 17-21, the DI+ line seemed to be converging with the DI- line, a bearish sign. However, the parabolic SAR was continuing to reflect increasingly bullish price action. By August 23, the DI+ line had reversed its course, diverging from the DI- line and confirming that "bullish" was the correct reading of AMZN.

Like most trend-based indicators, the parabolic SAR is much more effective during trending markets than those markets in a consolidation range. Also, the indicator tends to operate as if the trader is continuously in the market, simply looking for which side of the trade--long or short--is likely to be more profitable (hence, "stop and reverse" as opposed to, say, "stop and get out"). Nevertheless, the ability of the parabolic SAR to provide both effective locations for trailing stops as well as its ability to signal (or, at a minimum, confirm) entry and exit points, makes the parabolic SAR a valuable tool for technically-oriented analysts.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Parabolic Stop and Reverse: The Other Way of Stopping

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