An almost complete trading system
Welles Wilder’s Parabolic SAR (Stop And Reverse) is in principle an almost complete trading system. The indicator not only shows whether the observed stock is in an up or down trend, but also whether a stop loss is being followed at the same time.
Basic consideration of a “Parabolic SAR System
The mathematical calculation of the Parabolic SAR takes into account the general rule that a stop loss at the beginning of the exposure should be broader in scope and that later on it must secure the accrued profit as close as possible to the price. I will not go into the details of the calculation itself here, but the system is basically structured in such a way that the indicator (i.e. the stop loss) in the valid trend approaches the current price with every new high (in the uptrend) or low (in the downtrend) until the security is stopped by this stop loss and turned into an opposite position. Now a new, broad stop-loss is generated and drawn down again.
In the chart you can see very clearly how the Parabolic SAR oscillates around the prices or how the positions are turned. The Parabolic SAR works very well with strong trend movements! At the beginning of the movement, the stop loss is relatively wide, so that small counter-movements do not immediately endanger the exposure. With a longer duration, the indicator approaches the price more and more, i.e. the accumulated profits are closely hedged.
As the Parabolic SAR is in principle trend-following, the Parabolic SAR system has the usual problems of any trend-following system in sideways movements. Here, many position changes follow at short intervals and, in addition to many small losses, the fees are likely to become a serious problem.
In order to use the Parabolic SAR system successfully, one should think about a filter for the generated signals. Since the indicator generates a lot of signals in principle, it is probably better to ignore one or the other questionable signal.
Possible approaches for a filter:
- Use of weekly charts. Since price movements on a daily basis tend to be somewhat more random than movements on longer time levels and more useful trends are generated on longer time levels, a weekly chart acts as a filter to a certain extent
- consideration of a trend strength indicator. Since sideways movements are poison for a trend following indicator, the strength of the present trend can be used as a filter via a trend strength indicator such as the RAVI or ADX. It is conceivable to search for stocks with very high trend strength in order to use the next signal in the direction of the significant trend after a short correction.
- Another approach is the attempt to catch the beginning of a new trend in stocks with currently conspicuously low volatility. Using the Bollinger bands, one can determine, for example, whether a conspicuously low volatility is being (or has just been!) detected in the stock. From this one can deduce that a strong trend movement is overdue. One should then take this with the signal according to Parabolic SAR.
I think that the Parabolic SAR can generate highly interesting signals and, due to the stop-loss that has been added, it can be considered a trading system in its own right. However, I think it makes sense to filter the signals additionally in order to avoid many small losses in a row in sideways movements.