The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.
NEW YORK (
) -- In
, we showed how moving averages are used to trade in line with the primary trend of a market. Another indicator that works well in conjunction with moving averages is available on most trading platforms.
It is called the Parabolic Time/Price momentum indicator (also called Parabolic SAR)
. Both of these indicators are useful in trending moves, while working less well in trading ranges.
The definition strict definition of the Parabolic Time/Price Momentum system is complex and mathematical, and interested readers can find a complete exposition of the Parabolic System in Welles Wilder's excellent book "New Concepts in Technical Trading Systems". What is more important to our subscribers is what it does, and how it works. For our purposes, the parabolic system generates trailing stop loss points, which we use for risk management or to indicate the trend has changed. These trailing stops move closer to current prices as time passes. If price does not keep moving within the trend the trend is assumed to have ended. Each dot on a parabolic chart represents one of these prices. Notice how, over time, the dots move closer to price in a parabola - hence the name. We use parabolic indications to confirm moving average crossover signals, which gives us added confidence in trend direction.
There are some differences between the moving averages and Parabolic SAR, and these are both significant and useful - we will describe these below. Also note, we will discuss these methods as if they were "long only" methods, but in fact they work on the short side as well.
First, like moving averages, the
Parabolic System enters the market on strength
. Sometime a signal is generated before, and sometime after, moving average signals occur. We show two charts below, one with our 5 and 20 moving average, and one with the Parabolic System. Reading a parabolic chart is easy -
when price is above the dots the system is long, when below, the system is short, or in our case, out of the market
. Each dot represents a "stop" price, where traders exit the market (or reverse, if the system is being followed).
On the charts above, there are some things to notice. First, notice that both methods capitalize on major trends in the SPY. Second, the parabolic method often gives earlier and more frequent signals. Third, these methods both fail in trading ranges - and here is where moving averages tend to do better - they are slower so they result in more breakeven trades. This also highlights one of the important things about the parabolic method - and why it got its name! In the mathematical construction of the indicator, there is something called an "acceleration factor."
The acceleration factor kicks in after price has moved for a certain amount of time in a direction, and tightens up over time
. Another way of looking at this is it is a computer generated trailing stop loss that is triggered as price momentum wanes, or time passes. We show two more ETFs - one that is a strong uptrend, one that is a bit choppier. Notice how, on all these markets, these two methods fail in a sideways market, but do very well in a trend.
, we use, among other things, a combination of these two indicators to make projections, set stop losses, and otherwise analyze market trends. Individuals using moving averages can certainly incorporate parabolic methodologies into their trading systems. We find both of these to be useful in measuring, and projecting, price trends.
Fred Meissner is founder and publisher of
. Fred is a CMT and past President of the Market Technicians Association (MTA). He recently left Merrill Lynch's Market Analysis Department and Sector Strategy Department to form The Fred Report. A detailed bio is here: