While I generally like to trade with few indicators and very little on my charts, the Parabolic SAR is one indicator that can be quite valuable. Short for Parabolic Stop-and-Reverse, this indicator provides both entries and exits.
The indicator is composed of a series of dots, either above or below the price. When dots move from below to above the price bars, it is time to get out of longs or get short. When the dots move below the price bars it is time to get long, or get out of short positions. While the indicator provides buy and sell signals, they should not be trusted blindly. Therefore, the Parabolic SAR just provides potential trades. You'll then want to look at the stock from other technical angles to see if the buy signal is worth taking.
In the four cases below, I am mainly looking to see if a dominant trend is in place. Then I'll look to other indicators, such as volume or chart/price patterns, to see if they confirm the signal as well.
Health Care REIT (NYSE:HCN) been in a strong uptrend, and a Parabolic SAR buy signal indicates another wave higher may be starting. On May 13 the indicator moved below the price, after having been above for several days prior. The dominant trend is up, which could be confirmed with trendlines, but also by simply looking at the the amount of time the stock has spent trading above the Parabolic SAR dots. Despite the relatively high price, volume is also standing firm. Average volume is higher due to the volume spike on May 9, but even without that volume is comparable to prior uptrend months.
To me this indicates a healthy trend which could likely continue. A stop-loss for long trades can be placed with the Parabolic SAR, currently at $73.60. The SAR will continually rise though, acting as a trailing stop and, therefore, your stop loss order can rise with it. Eventually the price will hit a dot (and the dots will move above the price) signaling a potential reversal to the downside.
While Honda Motor Co. (NYSE:HMC) is in a uptrend, it is much less pronounced than the Health Care REIT is. As of May 13 the price is above the Parabolic SAR indicator dots, signaling a potential buy. Overall I think there may be a bit more upside, but there is resistance on the long-term charts between $41 and $41.25. If the stock can rise though that area the potential is greater for a bigger up swing to emerge. I'd prefer to see the stock move above that threshold before considering a long position. The Parabolic SAR once again provides the stop for a long position, currently at $39.18, but that will continually rise, acting as a trailing stop.
Hillshire Brands (NYSE:HSH) has been a classic example over the last several months of trading with a dominant trend using the Parabolic SAR. Since November, the price has predominantly stayed above the SAR dots and corrections have been relatively short-lived. If this pattern continues to hold, then another upside move into the $38 to 38.20 area is quite possible. The indicator provides a stop level of $33.20, currently. This risk is a bit high for what I think the upside is, but that risk will continually shrink so, barring any drastic sell-off, I like the long. If at any point the dots move above the price, take the profit (or loss) and exit.
The price of Walgreen Co. (NYSE:WAG) stock price also moved above its SAR on May 13. This stock is also in a well-defined uptrend, adding credibility to the SAR buy signal. Volume is holding steady, which is a positive sign. Since late 2012, when the price moved above the SAR, the following up move has lasted for some time, except for a period in February 2013 when when the stock moved predominantly sideways. Overall I like the long here. The SAR provides a fairly tight stop, currently at $47.75, and risk will continue to diminish as the trade unfolds. As with any SAR long trade, if the dots flip above the price, take profits/losses.
The Bottom Line
The Parabolic SAR can be a great indicator, as it provides trade signals as well as a trailing stop. Ideally, though, you want to trade signals that occur in the same direction as the dominant trend. A choppy market will result in multiple false signals, multiple losses or insubstantial profits. Risk management is always up to the trader though. While the indicator provides the entry and exit, taking the proper position size has just as much (or more) impact than where the stop-loss is placed. Trade within your risk tolerance, and use the Parabolic SAR to point out potential trade candidates that deserve a closer look.
At the time of writing, Cory Mitchell did not own shares in any of the companies mentioned in this article.