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December 4, 2010 - by Christopher Smith
  

How To Use The Parabolic SAR To Set Trailing Stops

The Parabolic SAR provides excellent exit points and can be used as an effective tool for identifying trailing stop-loss exits.
  
The Parabolic Stop and Reversal, more commonly referred to as the Parabolic SAR, was developed by Welles Wilder.  Calculation of this indicator is complex and will not be covered in this article.  However, it is an indicator that is commonly available as a standard technical study on most good charting software platforms.

The Parabolic SAR is a trend following indicator.  During uptrends the indicator is plotted below prices and continuously rises along with the upward trend.  Unlike a moving average, a rising Parabolic SAR does not move lower and for this reason works very well as a stop-loss.

In a downward trending market, the Parabolic SAR is plotted above the price bars and will follow the downward trend lower but will not rise.  It, therefore, also makes an excellent trailing stop for directional bearish trades.

Parabolic SAR

As price crosses over the Parabolic SAR a "stop and reverse" takes place, with the indicator moving from one side of the price bars to the next.  The indicator allows price to continue on its trend, but once that trend flattens or reverses the indicator continues to move in with the presumed trend and will intersect the price bars.  Once that intersection takes place it is a trigger to exit the trade.

In the Trading Room we do incorporate directional trades and the Parabolic SAR has demonstrated its value as a tool for exiting directional positions.  Initial stops are established when the trade is first opened without reliance upon the Parabolic SAR.  Once the trade develops the initial stop is then converted to a trailing stop based upon the Parabolic SAR.

This technique removes the guess work from our directional trading and prevents us from over thinking market pull-backs and corrections.  Adjustments are used for purposes of locking in profits, but are not employed to "fix" trades that are not working. 

By locking in profits through adjustments and exiting our directional positions once the directional move has exhausted itself we not only limit our losses on individual trades but we continuously make capital available for trades. 

Once a position is exited there is nothing preventing us from opening a subsequent directional position on the same underlying security.  We attempt to identify the primary market trend, trade with that trend, but recognize that each pull-back could potentially signal a reversal in the primary market trend.

Using a trailing stop forces us out of the market will profits, but does not prevent us from re-joining the trend once the interim consolidation has exhausted itself and the market is ready to return to the primary trend.

By using the Parabolic SAR a trader can enforce a rigid discipline that forces them to take profits.  When combined with a sound trend following system the two combined will permit a trader to enter positions consistent with the primary market trend and then force them to lock in profits along the way.

This indicator works best with trending securities.  Use of the Parabolic SAR when a trend is not underway may expose the trader to a significant number of whipsaws.  For this reason we believe it is best paired with a trend following system.

Wells Wilder, New Concepts in Technical Trading Systems

Steven B. Achelis, Technical Analysis from A to Z

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