Number 32

Screening with Parabolic SAR
and the Directional Movement Index (DMI)

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Overview

John Murphy, author of Technical Analysis of the Financial Markets, recommends using a filter to complement the Parabolic system. He suggests using the Directional Movement Index (DMI) to help eliminate whipsaws and false signals in the more sensitive Parabolic system. As a simple rule of thumb, he observes that the DMI and Parabolic SAR indicators can complement one another as follows: "When the +DI line is above the -DI line, all Parabolic sell signals can be ignored."

In this months newsletter, we will cover a basic Parabolic SAR and DMI filter as well as apply both indicators to a set of stocks, but first a quick overview of both technical indicators.

Parabolic SAR

The Parabolic System (or Parabolic SAR) was developed by Welles Wilder. Mr Wilder designed this indicator to supplement the other trend-following systems.

The Parabolic SAR is a "stop-loss" system used to set trailing price stops. The name of the system is derived from its parabolic shape, which follows the price movements in the form of a dotted line. When the parabola follows along below the price, the trader should be buying or going long. A parabola above the price suggests selling or going short.

The particular value of the Parabolic SAR is that it allows traders to catch new trends relatively early. If the new trend fails, the parabola quickly switches from one side of the price to the other, thus generating the stop and reverse signal.

Mr. Wilder built an acceleration factor into the Parabolic system. To allow the trend time to become established, the movement of the indicator starts off slowly - with the dots close together. As acceleration increases, the parabola move faster (with the dots further apart) until it catches up to the price action.

As with most indicators, Parabolic SAR performs best in trending markets, and is less reliable during sideways or congestive phases.

Directional Movement Index (DMI)

Generally speaking, there are two main buy and sell signals generated by DMI and are as follows,

1. A buy signal is given when +DI crosses above the -DI line.
2. A sell signal is given when +DI crosses below the -DI line.

For more information on the ADX/DMI, click see the following report.

For our screen, we will be following John Murphy's lead in using both the Parabolic SAR with the Directional Movement Index (DMI) as our technical screen conditions as well as our standard fundamental criteria (minimum price and volume levels). (See overview for quote)

The following screen includes several additions, but should be modified to suit your own trading strategy.

The technicals will be as follows:

Parabolic SAR (Stop and Reverse): SAR crosses price line Buy generated between 0 and 1 days ago

Parabolic SAR switches from above price to below.

Directional Movement Index: +DI crosses through -DI
Buy generated between 0 and 1 days ago

The +DI crosses up through the -DI based on the last traded close.

You could at this point also add in the ADX signal however if you do this I suggest expanding the number of days for each condition, otherwise it will be extremely unlikely to return results.

Fundamentals:

To shorten our list, the following price and volume conditions are added:

Close
=Greater than or equal to 5 Minimum price (close) of $5

Average Volume - 30 Day (thousands)
=Greater than or equal to 2000 Minimum average 30-day volume of 2 million (we need some liquidity).

Volume Ratio - 20 Day
=Greater than or equal to 1

Where volume ratio 20-day greater than 1.

Due to the number of results it is suggested that this strategy is applied to only one exchange at a time.

You can also add complementary technical indicators at this point or modify/add more conditions based on your trading style.

Results:

A look at the technical chart

In this section, we will have a look at the technical chart for CAG, AM and GHL from the NYSE and apply the Parabolic SAR, Directional Movement Index (DMI) and trendlines.

In looking at all three charts, none of the three will meet the ADX/DMI requirements as listed above. This signifies at best a small correction in all three. We will also look at all three stocks exactly 30 days from the date of this screen to see how accurate the ADX/DMI was.

This stock does not meet the trading requirements of the ADX/DMI, even though the Parabolic SAR has generated a signal.

This stock does not meet the trading requirements of the ADX/DMI, even though the Parabolic SAR has generated a signal.

This stock does not meet the trading requirements of the ADX/DMI, even though the Parabolic SAR has generated a signal.

While none of the three stocks resulted in a good chart, the screen was firstly only applied to one exchange, as well by altering the minimum volume requirements more results can be achieved.

What is most important here is that by applying the ADX/DMI in conjunction with the Parabolic SAR, a clearer picture of the strength of the trend is given.

30 days later.... Price changes for 3 stocks

March 24th close	April 24th close	% Difference
CAG : 20.89 AM : 21.35 GHL : 66.13	CAG : 22.27 AM : 21.74 GHL : 70.19	CAG : +6.6% AM : +1.8% GHL : +6.1%

Technical Charts 30 days later

Looking at the charts 30 days later, we can make the following quick observations: