Parabolic alternatives

By Volker Knapp
These tests will compare two related trailing exit rules that are similar to the Parabolic SAR system (see “The Parabolic stop”), but are more intuitively configured.

One of the Parabolic system’s trademarks is its favorable performance in fast-moving trends: Because it tracks price increasingly closely as time passes, it can capture more of the available profit than trailing exit approaches that might wait for a larger adverse move to occur.

A downside is the complexity behind the component that dictates the Parabolic stop’s speed increase, the “Acceleration Factor (AF),” which includes three non-intuitive parameters for fine-tuning the acceleration during up moves, down moves, as well as for defining the maximum allowed acceleration. To find the correct acceleration factors for the markets in a portfolio, traders must optimize these parameters. The two trailing techniques that will be tested here retain the Parabolic’s characteristics, but use a more intuitive definition of acceleration.

Strong trending periods are optimal for the Parabolic SAR, and it makes sense to apply the method after determining the market is trending. The two exit techniques approach this task differently: one is based on price/momentum and the other on a “signal-to-noise” ratio.

The first method is a “Chandelier”-stop variation that trails a stop below the highest price reached in a trade (or above the lowest low in a short trade), with the distance based on a volatility calculation. Starting at a liberal distance from the entry point, this stop allows room for countertrend movement early in the trade. The stop distance is progressively reduced by a certain fraction of the volatility. In the case of a long trade, when a stock is setting new highs in the trade the trailing stop distance is reduced more aggressively. Like the standard Parabolic, acceleration can be customized separately for long and short trades.

The entry rules for both systems are simple: buy on a breakout of a short-term high if the price is above a long-term moving average (reverse for shorts).

The second trailing stop method is based on using a signal-to-noise indicator. Trend smoothness is directly connected to higher signal-to-noise ratios. From a risk-reward standpoint, smoother trends — those that appear either “cleaner” or “faster” — are more desirable because they allow you to place tighter stops and protect more unrealized profit. One way to find smooth trends is by using Perry J. Kaufman’s Efficiency Ratio (ER).

In his book Smarter Trading, Kaufman defines the ER as the net price change over a period divided by the sum of the absolute values of all individual price changes. The ratio, which gauges market speed relative to volatility, oscillates from 0 (least amount of signal relative to volatility) to 1 (most signal relative to volatility). The higher the ER value, the tighter the stop. A very noisy, indecisive market doesn’t affect stop placement, faster moving trends reduce the stop by a small volatility unit, and highly directional prices (as measured by the ER) will shrink the stop distance the most.

For the complete article, see the September 2010 issue of Active Trader magazine. Click here to subscribe.



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