Technical Analysis Using Parabolic Stop and Reversal

There are two types of analysis which traders like us can use in making profit-winning decisions. We can either use fundamental analysis or technical analysis.

Fundamental analysis involves understanding the economic environment and characteristics of a company (e.g. the industry where it operates, its products, its long term plans) in order to estimate its value. Actually, fundamental analyses can be very tedious most of the time. You need to do this and that, study this and that. The difficulty in making involved usually drives new investors away.

On the other hand, technical analysis takes a different approach. It doesn’t care one bit about the characteristics of a company. Price is the only factor that is used in drawing technical analysis. Charts are used together with one or more indicators. In other words, technical analysis is the easier method we can use in predicting the likely direction of a stock price and the right time to buy or sell. But how is this easier when we need to make graphs and charts and indicators? Well, most of the trading platforms are already configured with technical analysis tools and the only thing you need to do is click and make your decision.

But don’t get me wrong.  I’m not saying that technical analysis is better than fundamental analysis. Both have their own merits and each of them can be performed via different strategies.

In this article, we will focus on a strategy used in technical analysis. Let us discuss about Parabolic Stop and Reversal.

What is Parabolic Stop and Reversal?

Parabolic Stop and Reversal, also known as Parabolic SAR, is a strategy that uses a trailing stop and reverse method to determine good exit and entry points.

The Parabolic SAR was developed by J. Welles Wilder. This kind of strategy is very simple to use.  When using one with your trading platform, you will notice “stop and reverse” price points. In the image below, the “stop and reverse” price points are the blue dots.

Why use Parabolic Stop and Reversal?

The Parabolic SAR assists us traders in predicting the future. By “predicting the future”,  I’m not pertaining to predicting who will win in the next NBA series, when you’ll meet the love of your life or when the next earthquake will happen. I’m talking about predicting the likely movement of a stock price at a point in time.

The Parabolic SAR is very useful in taking advantage of short-term price changes in the market.  It can help us assess whether an uptrend or downtrend will continue for a time or whether it is already at the brink of moving to the opposite direction. Hence, the use of a Parabolic SAR can help us attain the optimum position in a market to lock-in profits.

How to use Parabolic Stop and Reversal?

The Parabolic SAR picks up on a trend. This means that for a Parabolic SAR to be effective, an upward or downward trend must first be clearly identified.

One of the most important things to keep in mind is the positioning of the dots. A dot placed below the price is deemed to be a bullish signal, causing traders to expect the momentum to remain in the upward direction. Conversely, a dot placed above the prices is used to illustrate that the bears are in control and that the momentum is likely to remain downward.

When a stock price reaches the dot, it signals that you must stop and reverse your position, hence the term “stop and reversal”. This means that you need to close your current position and open an opposite position.  For example, if you currently hold a long position, you close it and open a short position and vice versa.

Some trading platforms have a feature which allows you set your trades automatically depending on the type of stops you have chosen. This means that you can make high-probable profits even if just you’re sitting comfortably on your couch, watching TV.

When NOT to Use Parabolic Stop and Reversal?

A word of caution must be said about the use of Parabolic SAR.  While this strategy is helpful in making more-probable predictions, reversing your position every time a stock price penetrates the SAR dot might also be dangerous. Parabolic SARs are ineffective when the market is experiencing consolidation.  This is evident in the image below.

Notice how the signals can lead to many false entries during periods of consolidation. Being whipsawed in and out of trades can often be extremely frustrating, even for the most successful traders.

Before closing or re-opening a position, it is best if you rely on multiple confirmations from different indicators. This can be done by using complimenting the use of SAR with other indicators such as the McClellan Oscillator, scholastics, moving averages, candlestick patterns, Bollinger bands and the like.

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