What is parabolic SAR?
Parabolic SAR is the commonly used term for the parabolic stop and reverse technical indicator that follows trends in a market and enables traders to determine potential reversals in price.
The parabolic SAR, originally named ‘Parabolic Time/Price System,’ was developed by J. Welles Wilder in the late 1970s. Wilder was a well-known and influential technical analyst who also developed and introduced other technical indicators like the average true range (ATR) and the relative strength index (RSI).
Sometimes referred to as ‘the stop and reversal system,’ it is a popular indicator and can be used as part of a strategy to trade forex and different types of securities, such as stocks or shares.
How is the parabolic SAR displayed on a price chart?
The parabolic SAR is graphically displayed on a chart as a series of dots, plotted either below the current market price or above the current price of a currency or asset.
When the single parabolic line (series of dots) appears above the price bars, it signals a bearish trend. Conversely, when the parabolic line is displayed under the price bars, it is considered a bullish signal.
In the process of developing the indicator, the shape of the pattern reminded Wilder of the parabolic curve in geometry, hence, the name of the indicator.
Primary functions of the parabolic SAR
The parabolic SAR comprises three primary functions, namely:
- To highlight the current price direction or trend.
- To intend to forecast a reversal in the prevailing trend.
- To provide potential entry and exit signals during a reversal.
Calculation of the parabolic SAR
The parabolic SAR is calculated by charting software on trading platforms. However, it is helpful to know the intrinsic details of the indicator.
The indicator is calculated differently, depending on whether it is being utilised during an uptrend or downtrend.
- Uptrend: PSAR = Prior PSAR + Prior AF (Prior EP – Prior PSAR)
- Downtrend: PSAR = Prior PSAR – Prior AF (Prior PSAR – Prior EP)
Where:
- EP (extreme price) = Highest high for an uptrend and lowest low for a downtrend, updated each time a new EP is reached.
- AF (acceleration factor) = A constant (default) of 0.02, increasing by 0.02 each time a new EP is reached, with a maximum of 0.20.
However, many trading platforms allow a trader to overlay the parabolic SAR onto any price chart.
The calculation creates a dot (which can be connected with a line) below the upward price trend, or above the declining price action. The purpose of the dots is to highlight the current price trend.
When the current market price dips below the rising dots, the dots quickly move on top of the price bars. Contrarily, when the price breaks through the falling dots, the dots flick below the price below.
Trading with the parabolic SAR
The parabolic SAR is ideal for trading trends in financial markets, specifically when the trend continues for a considerable period of time.
Basically, the indicator enables traders to identify when the current price trend will end, or when it is about to terminate.
As mentioned, the parabolic SAR will create a parabolic line (a series of dots) above and below the price trends in a price chart. Typically, these dots will be either green or red.
The slope of the parabolas is also an indication of how significant the momentum of a trend is – the steeper the slope, the more momentous the trend, and vice versa.
Trading with the parabolic SAR, the basic assumption is to buy when the dots (green in colour) move below the current market price (represented by price bars). This signals an uptrend in price. Conversely, when the dots (red in colour) move above the price bars, they indicate a downtrend, signalling it is time to sell.
In short, when the change happens, (the dot goes from below to above the next price candle or vice versa), this signals that a potential price reversal is imminent.
The change in the direction of the dots will constantly create trade signals because the trader will always have a trading position (short or long) available. This can be profitable when the price makes big swings.
However, there is also the possibility of losses when the price is making small moves in each direction, which is referred to as a choppy market.
Therefore, to avoid possible losses, it is helpful to use other indicators, such as a moving average (for example a 20-period moving average) to determine and validate the overall trend direction. For instance, if the overall trend is downward, only take short trade signals (when the dots flip on top of the price candles) and then exit when the dots move quickly below the price candles.
The parabolic SAR is also a method to set stop-loss orders. Keep in mind that as the price declines or rises, the parabolic SAR will soon follow. Therefore, make sure that you move your stop-loss to match the level of the indicator after each price candle.
Although a useful indicator to indicate price trends, it is a good idea to use the parabolic SAR in conjunction with other technical indicators like stochastics (a momentum indicator) and moving averages (as already mentioned). Another indicator that can possibly be utilised is the directional movement index (DMI), identifying in which direction the price of an asset or currency is moving. The DMI indicator was also developed by Wilder.
Advantages of parabolic SAR
- The parabolic SAR will highlight a strong trend, enabling a trader to stay in the trending move.
- It gives an exit signal when there is a move against the trend, which signals a reversal.
Disadvantages of parabolic SAR
- Parabolic SAR does not measure the actual strength of a trend, only its direction and duration.
- In the absence of a clear trend, it will constantly flip-flop above and below the price. Such a choppy market can last all day, causing a trader big losses if he or she solely relies on the parabolic SAR for trade signals.
- Can give false exit signals because the price immediately starts to move in the trending direction again.
- Parabolic SAR is not typically recommended to be used as a stand-alone indicator to produce trading signals.
Note: This article does not intend to provide investment or trading advice. Its aim is solely informative.
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