Monday, December 15, 2008

Using the Parabolic SAR to determine exit points

In general, exiting a trade is probably tougher for most investors than entering one despite the fact that there are many ways of doing so, either technically or quantitatively. Quantitative approaches include fixed stops that will trigger once a profit percentage is reached or trailing stops that follow the price and are triggered once the price begins to move against the position by a designated percentage. Technical criteria include trend-line violations or a reversal in a technical indicators. One such indicator that is particularly useful in determining exit points is a called the parabolic SAR.

The parabolic SAR (short for Stop And Reverse) is a trend following indicator invented by J. Welles Wilder, Jr. a mechanical engineer who also created the RSI (Relative Strength Index) and the DMI (Directional Movement Indicator). It is based upon the theory that the path of a strong trend is shaped like the arc of a parabola. In up-trends, the indicator is displayed as a series of dots underneath the price bars; in down-trends, the dots are above the price bars. A “buy” position is entered when the indicator moves below the price, and a “sell” position is signaled when the indicator moves above the price. (See below charts.)

Once in a position, think of the dots as a type of trailing stop. From the charts below you can see that the dots are farther away from the price at the beginning of a move and tighten up as the trend continues. The position of the indicator is controlled by two variables: the step and the maximum step. If the step is set too high, the indicator will fluctuate more often and whipsawing will occur. The maximum step controls the adjustment of the indicator as the price moves. Lowering the maximum step furthers the indicator from the price. Wilder recommends setting the step at .02 and the maximum step at .20. Most charting services will allow the user to tweak these variables.

Potential problems
The parabolic SAR works great in trending markets but is miserable during periods of consolidation. One way to minimize this effect is to look at longer time periods—a weekly chart instead of a daily chart, for example. You can see from the charts of the Nasdaq 100 tracking stock, the QQQQ, that the parabolic SAR switched three times on the daily chart during brief consolidation periods that occurred from September to November, but this whipsawing is not evident in the weekly chart where the indicator has signaled a downturn since the beginning of September. This is not to say that using a longer time period is the way to go, either, for you do lose some accuracy when it comes to timing your entry and exit points.

So what's the solution? One way is to use other technical events like the breaking of a major support or resistance line or the breaking out of a base. Another way is to use other technical indicators for trend confirmation. Wilder himself estimated that trends occur only about 30% of the time and suggested using an oscillator such as his ADX (Average Directional Index) to determine the direction of the trend. Other indicators that can be used effectively are the CCI, the MACD, and moving average cross-overs.

Where to find the parabolic SAR
If your charting service doesn't carry the parabolic SAR, you can find it at Yahoo! Finance and which has a whole boat-load of charting tools along with an in-depth description of each and how to use it. Have fun!

1 comment:

Martin Rogers said...

I really enjoy your writing, and we are learning very much! My cousin and I are new to investing and we are happy that we found you!


Martin Rogers
Wheaton, IL