The Parabolic Trading System by Thom Hartle
Traders are always searching for methods with which to manage risk through the use of stop-loss orders. One method that has been proposed for determining stops is by using a mechanical formula based on the parabolic indicator, also known as the stop and reverse (SAR). How does it work?
The parabolic time/price system was introduced by J. Welles Wilder in New Concepts in Technical
Trading Systems. The trading concept itself is an automatic reversal system, in which the system always
has a position that is either long the market or short the market. For example, the first entry for a long
position occurs when the recent extreme high is violated, at which point the trailing stop and reverse
(SAR) order is placed at the recent extreme low price. Each day, the SAR order will advance higher in
price, slow at first and then more each day. If you were to chart the SAR order price level, it would
resemble a parabola (Figures 1 and 2). If the sell SAR order were to be executed, then the buy SAR would
be placed at the most recent extreme high, and each day the buy SAR is lowered, again slow at first but
increasingly lower each day until the market moves above the buy SAR. Then the system is back long,
with the new SAR trailing from the most recent extreme low price.
This trading system has two points of appeal. First is the initial room that a trade is given between the
entry price and the SAR order. Not all markets begin to trend immediately, but in time a trend may
develop, and making an allowance for this possibility is promising. The SAR order has minor adjustments
to make at first, but after a period of time the SAR begins to catch up with the market, automatically
adjusting the distance between the SAR order and the current market.
If the trend were to reverse, the stop and reverse order would be hit, and with any luck lock in a profit and
be positioned with the new trend. Unfortunately, the trading method requires a fairly strong trend because
otherwise, the buy SAR orders would be executed near the top of the trading range and the sell SAR orders
executed near the bottom of the trading range (Figure 3), resulting in trading losses. However, some
traders use different entry rules, and the parabolic indicator is only used for confirmation of the trend and
for selecting a stop-loss order late in the trade.