Parabolic stop

The parabolic stop is a trailing stop technique developed by Welles Wilder and explained in his book New Concepts in Technical Trading (Trend Research, 1978). It’s the primary component of what he calls the “Parabolic Time/Price” trading system. The basic principle behind the parabolic stop is a calculation that automatically raises (in the case of a long trade) or lowers (in the case of a short trade) a stop-loss order that protects existing profits in a trade.

For simplicity, the following discussion is given in terms of long trades — the rules are inverted for short trades.

Calculation

The formula for calculating the parabolic stop level for tomorrow’s trading day (when using daily price bars) is:

Ptomorrow = Ptoday + AF * (EPtrade - Ptoday)
where

Ptoday = Today’s parabolic stop value

AF = Acceleration factor; the default value which begins at .02 and increases by .02 increments (for each bar that establishes a new high during the trade) to a maximum of .20

EP = Extreme price since the trade was initiated (highest high if long, lowest low if short) To walk through the calculations, assume a long trade was established yesterday in the Euro/U.S. dollar rate (EUR/USD) at 1.1965, with an initial stop-loss of 1.1870 that is still in effect today. Today’s high of 1.2084 was higher than yesterday’s high, which means it is the extreme price (EP in the previous formula) since the trade began. This changes the formula slightly:

Ptomorrow = Ptoday + AF * (Htoday - Ptoday)
where

Htoday = Today’s high (the extreme price)

Because this is the first day of the calculation, there is no parabolic stop level. This means we must use the initial stop for the trade (1.1870) as Ptoday in the formula. Plugging in these values results in:

Ptomorrow = 1.1870 + .02 * (1.2084 - 1.1870)

Ptomorrow = 1.1870 + .0004 = 1.1874

If tomorrow EUR/USD rallies to a new high of 1.2250, the parabolic stop level for the following day would be:

Ptomorrow = 1.1874 + .04 * (1.2250 - 1.1874)
Ptomorrow = 1.1874 + .0015 = 1.1889

Notice here the acceleration factor increased from .02 to .04 and the previous day’s parabolic value is now used in the formula. The greater the acceleration factor, the more “tightly” the stop will track prices. The AF increases by .02 only for a bar that establishes a new EP (high price) in the trade. If the stock had not made a new high, the previous high of 1.2084 would have been used as the EP and the AF would have remained at .02.