Trend following is a common strategy for traders in the stock market, but spotting opportunities can be difficult. Today we’ll consider a combination of indicators included in the TradeStation platform that may help: parabolic SAR and moving averages.
Parabolic SAR (“stop and reverse”) is a trend-following study that finds potential reversals. It draws dots below the price when a stock is rising, and above the price when it’s falling. The dots mark potential boundaries of the trend. Bullish trends have dots below the stock price, while bearish trends are plotted above. When prices break the dots, parabolic SAR stops and reverses in the other direction. The indicator adjusts to accelerate along with a trend, making it follow more closely than a traditional trend line. (This is the parabolic aspect of parabolic SAR.)
The second indicator is a moving average, one of the most common chart studies. Moving averages show the mean closing price over a certain period of time. Stocks above longer-term moving averages like the 200-day are often in longer-term uptrends, and stocks below it after often working lower.
Parabolic SAR can be viewed as a short-term trend indicator that always gives either bullish or bearish signals. Therefore, it can produce a lot of “noise” — especially in a sideways or neutral market. Traders can use moving averages to filter the results. For example, they may only recognize bullish signals from parabolic SAR when stocks are above their 200-day moving averages. And they may only act on bearish signals with stocks under the same average. That way, the indicators can help confirm each other.
Trend Following With Parabolic SAR
Trend followers act on the belief that a greater number of buyers than sellers will increase prices over time. Some trend followers buy dips in rising companies, looking for higher lows to be followed by higher highs. The advantage of this approach is it provides potentially cheaper entry prices. The drawback is that traders might buy dips too soon, or enter a stock at the beginning of a major reversal.
Parabolic SAR offers an alternative to traditional dip buying because it will flip bearish when a pullback goes “too far” (past the dot). This can provide trend followers with an objective method for entries and exits.
Next, traders may also want to avoid acting on Parabolic SAR immediately after the signal appears. Rising prices will usually turn it bullish, so a small dip may follow. But as long as the dots remain below its price, the indicator could trigger a long entry. (Just the opposite is true for bearish positions.)
Adding Parabolic SAR to Charts
To use parabolic SAR on TradeStation, open a chart study from the Apps button in the top menu. Then click on “Studies → Add Study…” A dialog box will appear.
In the box make sure the “Indicator” tab is selected on the left. Then scroll down the list and select Parabolic SAR. Click OK.
It may open the Customize Indicator box, which will let you change colors and other aspects of the study. Click OK when done.
Adding Moving Averages
Following the same steps, customers can access moving averages by selecting Mov Avg 1 Line in the Add Studies dialog box.
This indicator defaults to a nine-bar interval. You can change the period in the Customize Indicator Box by clicking on the Inputs tab to the left and changing the Length to 200. There’s also a Color tab for customizing the line. Line thickness can be adjusted with the “Style” tab.
In conclusion, trend following may sound like a viable strategy. However it can be more difficult than expected because of sharp countertrend moves. These unanticipated swings can draw traders into positions early, and then move significantly against them. Parabolic SAR, combined with moving averages, can help overcome this difficulty by helping confirm that the countertrend move has ended. It can then provide an non-subjective yardstick for knowing when to remain in a position and when to exit.