The Parabolic Stop and Reverse, more commonly known as the Parabolic SAR, is a trend-following indicator developed by J. Welles Wilder. The parabolic SAR indicator was developed to help traders locate buy and sell signals for current trends and determine when to enter and exit trades based on an asset’s momentum.
One of the most interesting aspects of this indicator is that it assumes that the trader is fully invested in a position at all point in time. For this reason, it is of specific interest to those who develop trading systems and traders who wish to always have money at work in the market.
The Technical Indicator: The parabolic SAR is a technical indicator used to determine the price direction of an asset, as well as draw attention to when the price direction is changing. The Parabolic SAR is a trend following indicator thus helpful while market is either in uptrend or downtrend.
In case market moving sideways; using parabolic indicator could give false signal thus probability to hit stop loss goes high resulting into losses.
It is always advisable to use parabolic SAR in conjunction with another indicator e.g. 50-Day or 200-Day moving average.
Parabolic SAR on Charts: The parabolic SAR indicator appears on a chart as a series of dots, either above or below an asset’s price, depending on the direction the price is moving. When a dot is placed below the price then market is moving upward and when a dot is placed above the price then the market is moving downward.
When the dots flip, it indicates that a potential change in price direction is under way. For example, if the dots are above the price, when they flip below the price, it could signal a further rise in price.
Calculation of Parabolic SAR: The Parabolic SAR (PSAR) indicator uses the most recent extreme price (EP) along with an acceleration factor (AF) to determine where the indicator dots will appear.
The Parabolic SAR is calculated as follows:
Uptrend: PSAR = Prior PSAR + Prior AF (Prior EP – Prior PSAR)
Downtrend: PSAR = Prior PSAR – Prior AF (Prior PSAR – Prior EP)
EP = Highest high for an uptrend and lowest low for a downtrend, updated each time a new EP is reached.
AF = Default of 0.02, increasing by 0.02 each time a new EP is reached, with a maximum of 0.20.
What this calculation does is create a dot below the rising price action, or above the falling price action. The dots help highlight the current price direction. The dots are always present, though, which is why the indicator is called a “stop and reverse.” When the price falls below the rising dots, the dots flip on top of the price bars. When the price rallies through falling dots, the dots flip below the price below.
In addition to dot position, dot spacing is also revealing. At the beginning of a new trend, the parabolic SAR dots will start close together and spread further apart as momentum accelerates and the trend fully develops. As momentum slows, the parabolic SAR will catch up to the price, and the dots will once again become more compressed. Which is quite visible in above given chart.
Potential Indicator for Entry/Exit in the Market: When dots switch from above the price to below the price this could be a potential buying opportunity.
Whereas when dots switch from below to above the price could signal selling opportunity in the market.
While flipping of dots from above to below or otherwise is signal for buying or selling opportunity but it is always advisable to wait for at-least 5 dot to confirm the switch in trend.
How to Trade with Parabolic SAR: The basic use of the Parabolic SAR is to buy when the dots move below the price bars—signaling an uptrend.
Use parabolic SAR to sell or short-sell when the dots move above the price bars—signaling a downtrend.
The Parabolic SAR can be a good indicator if the price is making big swings back and forth—producing a profit on each trade—but when the price is only making small moves in each direction, these constant trade signals can produce many losing trades in a row. In other words Parabolic SAR works exceptionally well in trending market either uptrend or downtrend but prone to produce false signals in sideways market thus could result into losses.
The Parabolic SAR as Stop Loss Strategy: If we enter a buy trade then we can place our stop loss on the dot just underneath the candle at the entry point or if short sell a stock we could place our stop loss at the dot just above the candle where we short a stock.
Indicators to Complement to the Parabolic SAR: It is always advisable not to enter or exit the trade every time parabolic SAR gives a signal.
Wilder recommended using other indicators like the average directional index momentum indicator to confirm the strength of the existing trend. Other indicators that complement the SAR trading signals include moving averages and candlestick patterns.
Use parabolic SAR in conjunction with indicators like moving average to confirm the trend reversal or continuation of current trend.
For example, SAR sell signals are much more convincing when the price is trading below a long-term moving average. The price below a long-term moving average suggests that the sellers are in control of the direction and that the recent SAR sell signal could be the beginning of another wave lower.
Similarly, if the price is above the moving average, focus on taking the buy signals. The SAR indicator can still be used as a stop-loss, but since the longer-term trend is up, it is not wise to take short positions.
- The main advantage of the indicator is that, during a strong trend, the indicator will highlight that strong trend—keeping the trader in the trending move. The indicator also gives an exit when there is a move against the trend, which could signal a reversal.
- The major drawback of the indicator is that it will provide little analytical insight or good trade signals during sideways market conditions. Without a clear trend, the indicator will constantly flip-flop above and below the price.