Stop and Reverse: Lumber's Long Slide

11/16/00 01:59:24 PM

by David Penn

After oscillating through a five-month consolidation between 325 and 360, lumber broke through the bottom of its range, losing 38% on its way to a low of 200. In spite of the occassional one-day rally, lumber is still falling.

Security: N/A
Position: N/A

The temptation to talk about housing starts and increasing lumber futures prices in 1999 compared with the economic slowdown and five-year lows in lumber futures here in 2000 might be great. But the fact of the matter is that lumber futures have spent the vast majority of 2000 going down. So now the biggest question on the minds of those looking to participate in one of the most unequivocally bearish futures markets this side of gold is a perennial, but simple, one: how long will lumber's slide last?

The current lumber bear is a sizeable one. Measured from an intermediate peak in May 1999, lumber is off 53% and, looking at the November contract, has shown little sign of retracement (measured against a 40-year high of $485 reached in early 1993, lumber is down 58%). The moving averages for November lumber (not shown) are in a relentless downtrend.

The downward resistance trendline points the way, but the parabolic stop and reverse (SAR) provides the entry and exit points along the trend. Note how the trade shifts from long to short and vice versa when prices intersect the trend.

Graphic provided by: FutureSource.com.

A downward sloping trendline connects highs in June, September and November. Looking at this line, we note precious few trendline breakouts and only enough touches to make the trendline valid. What this means, in part, is that there is a relative lack of buying pressure in the lumber futures market.

With moving averages and trendlines coming up a bit short for trading purposes (no pun intended), one indicator that is almost exclusively equipped for a market trending as lumber has been over most of 2000 is Welles Wilder's parabolic stop and reverse, or SAR for short. The SAR not only provides efficient entry and exit points for trading, but also, through its parabola-like "French curves", shows clearly the relative heft of the various up and down moves within a trend. The SAR also helps establish effective stop points, with closer stops when prices move against the trend and looser stops when prices are moving both with and faster than the trend. Note the chart of November lumber--in particular, the way that prices rise to intersect both the downward and upward curving parabolas. Each of these parabolic curves is actually a line of dots representing appropriate stop placement points, and the ability of the SAR to calibrate stop placement is shown by the way price and the parabolic stop points converge right before the trend shifts--albeit at times only briefly--from downward to upward or vice versa.

This underscores one of the principle benefits of the parabolic SAR. The indicator allows a trader to be continuously in a market by pointing out the correct position at any given spot in the trend. For example, a short position would have been correct for virtually all of June and August, when the SAR was above prices. Periods in both July and September, when the SAR was below prices, would have allowed for profitable, short-term net long positions. Also, the specificity of the SAR (because of the stop points provided) make it a superior trending indicator over moving averages in many ways. In a truly trending market, such as lumber shown here, the whipsaws against SAR are very infrequent. Further, the subjectivity often involved in dealing with price/moving average crossovers (such as how much crossover does a crossover need in order to count? 5 ticks? 10 ticks? 15?) becomes virtually nonexistent. An additional benefit is the acceleration factor, which helps the indicator keep up with the persistent movement characteristic of a trending market.

Note: next time we will take a closer look at the formula for SAR, as well as answering the question, where does the first SAR trade begin?

David Penn

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

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WILDER'S PARA SAR

Stop and Reverse: Lumber's Long Slide

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