How to Use Parabolic Indicators

05/16/2011 12:36 pm EST

Focus: STRATEGIES

Parabolic indicators are widely available and can be useful tools for trading in the direction of the trend, as well as defining favorable exit points.

Let’s begin this discussion with a basic definition of a parabola. According to good old Merriam and Webster’s Dictionary, a parabola is a “Plane curve generated by a point moving so that its distance from a fixed point is equal to its distance from a fixed line; the intersection of a right circular cone with a plane parallel to an element of the cone; something bowl shaped.”

The parabolic indicator we will discuss here is a strategy utilizing what many call a stop-and-reversal (SAR) method, which earns this indicator the name “Parabolic SAR.” Parabolic SAR, also known as Parabolics, is available on many charting platforms including MetaStock, TradeStation, etc.

Parabolic SAR was created by Welles Wilder, a name well known to technical analysts. Wilder also created the relative strength index (RSI) and directional movement index (DMI). This indicator is used to establish trailing price stops for either long or short positions. Note that this indicator was designed to be used to establish stops rather than discerning a stock’s direction or trend.

Welles intended that the equity’s trend should be determined first, then he would use the Parabolic SAR to trade in the direction of the established trend. At the beginning of the trend, the Parabolic SAR will generally show a greater distance between the price and the trailing stop. As the stock furthers its trend, the distance between the stock’s price and the indicator will lessen; therefore, the stop-loss will diminish.

What does the Parabolic SAR look like? It is the red dotted line overlaid on the daily chart of Google (GOOG) below:

Click to Enlarge

See how the dotted line tracks along with the stock? That is the nature of the Parabolic SAR. One use of this indicator is when the stock’s price crosses above or below the Parabolic line itself, as a potential buy or sell signal.

At BigTrends, we often incorporate Parabolics into trading screens and systems as a confirmation of a trend or an indication of a trend ending/reversing. It is often useful as a factor built into the “exit” side of a trading system.

As with most technical indicators, combining Parabolics with other indicators can lead to a powerful trading tools, screens, and systems. Test different methods, techniques, optimizations, and inputs on trading software in order to supercharge your trading.

By the Staff at BigTrends.com