The parabolic system is a useful indicator that tells us when to get out of a good trend when we are doing our technical analysis in stock market trading and investing. The Parabolic Time/ Price System is a trend-following indicator with a difference. Instead of seeking to define a trend, like a moving average, it sets out only to help us effectively harvest good trends. It beings by assuming we are following a trend. It then sets a test that the trend must pass. When the trend fails the test it signals us to sell.
It is easy to mistake the parabolic system for a moving average, because they can look similar on a chart. However, they are quite different. A moving average is a way of smoothing out price data so that we can see the underlying trend. The parabolic simply sets stop-loss levels. These stop-loss levels are based on a expectation of how a strong trend will unfold.
History of Parabolic System
The parabolic system was invented by J Welles Wilder Jr, an American who invested a brace of today’s most popular and most effective indicators in the 1970s. The concept behind the parabolic system is that strong trends should see the price move over time. It therefore sets levels the price should reach based on an acceleration factor. In other words, it gives an emerging trend time to prove itself, but as time goes on it demands continued movement. If this movement is not forth-coming, then it locks in the profit already achieved by taking us out of the investment.
Stop Loss Level
The parabolic sets a stop-loss level every day. What is unusual, compared to other indicators, is that the parabolic concerns itself not with the day just completed but with tomorrow, and sets a stop-loss for the next day on the chart. The price must stay above this stop-loss level tomorrow, or we are signaled to sell. There is no need to wait for the closing price as is the case with most indicators. The parabolic stop-loss is set for the day and if the price touches or goes through it we are signaled to sell.
The parabolic sets the stop-loss level for tomorrow by assuming that the trend will continue to move using an acceleration factor. There is one situation, described below, where this does not apply, but most of the time the parabolic system assumes the trend will continue to accelerate. It therefore follows the trend upward in a curve that tends to get steeper and steeper. Hence its name- the path it follows resembles a parabola.
How to use Parabolic Time/ Price System
The rules for calculating the parabolic system are quite difficult to describe and to understand. It would be easy to frighten most readers with a complex description of the calculation, Instead, what is necessary for practical use is to simply understand what the process is in general terms.
We start by assuming there is a trend. If there is trend, then there is a low on the chart that was the furthest point that the previous down-trend reached, and this is the starting point for the new uptrend. The low of this bar is the parabolic stop for the day the new investment is bought.
For every day after that until the price hits the latest parabolic stop, the parabolic stop is moved higher using an acceleration factor. There is one exception:
- The parabolic stop can never be higher for tomorrow than then low of today or yesterday. If its normal calculation would take it higher than the low of the last two days, it is set for tomorrow at the lower low of those two days. This explains why we will sometimes see no increase in the parabolic stop level for a day or so.
There is a limit to the acceleration factor. The standard acceleration factor used by Welles Wilder was 0.02. We start with 0.02, and each day that new high is made, the acceleration factor is increased by 0.02. However, when the acceleration factor reaches 0.2, it no longer increases, but is held constant at 0.2. The parabolic stop will continue to rise, so we will not easily observe any change.
Chart 4-1 shows parabolic stops on a daily bar chart of GUD Holdings. Since we are using a daily chart, this would be a trading situation rather than an investment. Our trade begins on the day marked Day A- January 16, 2004. We will return to why that day was chosen in a moment. In the software used to create this chart, each day after Day A has a dot under it. That dot is the parabolic stop for the day of the bar. Some software will show a dot under Day A as well, which will be the low of the lowest bar before the trade was taken. In this case, that would be the low of the second and third bars on the chat. The first stop shown by our software is for the bar after Day A, which is a little higher than that low, as the minimum acceleration factor has been applied to it.
The most important parabolic stop on any chart is the one we should act on tomorrow. In the software we are using for chart 4-1, that stop level is shown at the top left of the screen. If we so wished and we have a broker who accepts such orders, we could place a stop-loss order in the market at that price. At the end of each day, we could revise the stop-loss order until it was eventually triggered.
In the example of chart 4-1, the parabolic stop was triggered the next day. When charted after the close of the day on which the stop was triggered, the chart would look like chart 4-2, where we see the parabolic stop dot about halfway up the last bar on the chart.
The parabolic time/ price system is technically known as a stop and reverse (SAR) system. This means that when a stop is hit, the position is reversed. This is easy in futures markets, which Welles Wilder had in mind primarily. In shares market, it would be necessary for the trader to have a facility with their broker to sell short, which will generally only apply to large traders in Australia, though it is much easier in the US.
So, the parabolic system assumes that once a stop is hit, we sell our holding and go short. It therefore calculates a stop above the price bars, which is the stop-loss for someone who had borrowed stock, sold it and was holding to make a profit by buying it back at a lower price. If the price were to rise instead, they would make a loss; hence, their stop is above the bars. This explains two things about the two charts we have looked at so far. First, it explains the dots above the first four bars on chart 4-1 and the bar a short way up the bar for Day A that started our trade by signaling us to buy.
Second, it explains the parabolic stop for the next day on chart 4-2. That stop is the recent highest high less an acceleration factor and applies to the short sale the parabolic assumes that we have made.
Now, in practice, most Australian traders will only use the parabolic system to give them stop-loss signals when they are buying, not short selling. The parabolic system is excellent for this purpose, but with an important caveat. Like all trend-following indicators, it woks best in strong trends.
If the stock moves up slowly, or simply move sideways, then the parabolic system will not magically produce profits. This is well illustrated in chart 4-3, which shows an earlier period for the same stock, GUD Holdings, that we used in chart 4-1. In the period covered by this chart, GUD Holdings moved essential sideways. Close inspection for the bars that triggered the buy and sell signals shows that only the broker would have been happy, because it generated lots of transactions, but little profit.
It is possible to change the acceleration factor, but this should only be done with great caution and extensive testing. Welles Wilder’s standard acceleration factor seems to have been chosen carefully to suit situations.
Unlike many other indicators, parabolic stops are generated from the high and low prices rather than the closing price. It is therefore equally applicable for traders using daily prices or investors using weekly prices. Investors need to be a little careful here, because different charting software handles the data in varying ways, so if parabolic is to bused on weekly data, it is important to ensure that the correct calculations are being made by reference to the manual for the software concerned.
Chart 4-4 shows a weekly bar chart of GUD Holdings with the parabolic stops. This shows that an investor taking each parabolic buy signal would have made good profits when GUD Holdings trended strongly on the tree occasions marked on the chart.
However, the sideways period from late 2002 and mid-2003 yielded unsatisfactory results, though fewer than the daily parabolic in chart 4-3.
Disadvantages of Parabolic System
There are two other important points to notice on chart 4-4. parabolic is by no means a perfect indicator. First, notice how at A and Bon the chart parabolic triggered inappropriate sell signals for three days at A and one day at B.
Second, the series of parabolic stops marked C on the chart looks like a good trending move. Indeed it was- however, the range from top to bottom of the dots marking the stops is misleading.
The big spike down that ended the previous uptrend determines where the stops start, but the investment was started much higher and only made a small profit. Worse, had the investment gone wrong in the early stages, the stop-loss level would have been a long way below the entry price and involved a considerable percentage loss.
These disadvantages of parabolic have led some analysts to prefer using it only to get out of trades and investments, preferring other ways to identify when a strong trend is likely.
Other Uses of Parabolic System
Parabolic has two other applications for which it is useful. The first is to use it to get out of very fast moving uptrends, when other methods do not give signals at all, or give them too late. It is therefore ideal in speculative stocks and the wild final stages of bull markets.
Chart 4-5 shows an example where a trader might have used parabolic to exit a short, sharp uptrend with a nice profit. If you find yourself with a stock that seems to be going straight up, parabolic may be your best friend- unless you are blinded to it by greed.
In chart 4-5, assume you were lucky enough to have a broker that got you some Senetas Corporation shares at the end of June 1999. Your plan was to take a quick profit. It lists at 20.6 cents and closes the first day at 27.5 cents. Twenty-three days later it hits its high for some time of 53 cents. Parabolic would have signaled you to sell two days after the high, the worst price that day being 47.5 cents. To have hesitated would have been to give quite a bit of your paper profit back to the market.
At the other end of the spectrum, the second useful way to employ parabolic is in long-term investments. From time to time, investors are lucky enough to find themselves in a great growth in situation.
Most of them will end up doing one of two things. They will snatch a profit too early and miss most of the move or they will fall in love with the stock for life and end up losing much of their paper profits. Parabolic was designed for short-term trading, but it can serve investors well on a monthly chart.
Chart 4-6 is another look at GUD Holdings, this time on a monthly chart. It shows that we might have bought GUD Holdings around $2 early in 2002 as it broke out of a wide sideways period and began trending. At the end of the chart it is at $8 and the monthly parabolic has still not given a sell signal.
Yet, we have seen on earlier charts how daily and weekly parabolic stops took us out. Clearly, this is a textbook-perfect example and it will only happen rarely. However, it is worth keeping in mind by investors who happen on to one of these dream situations.