What is the Parabolic SAR?

05 January 2021

    Parabolic SAR indicator, short for Parabolic Stop and Reverse, is yet another one technical analysis indicator designed and developed by J. Welles Wilder. Parabolic SAR indicator is simple and it has a pretty straightforward interpretation with its main purpose being to indicate reversals in trend direction. Parabolic SAR is plotted as a series of dots above and below the chart price. The plotted dots indicate the direction of the trend. If the dots are below the chart price, Parabolic SAR indicates that we are in an upwards move. On the contrary, when the dots are plotted above the chart price, then this is an indication that the prices are in a downwards move.

     

    Parabolic SAR Calculation

     

    The calculation of the Parabolic SAR values is pretty straightforward. The equations use two variables to calculate the indicator’s value, the most recent extreme price (EP) and an acceleration factor (AF). The Parabolic SAR values are then calculated as follows

     

    Uptrend: PSAR = Previous PSAR + Previous AF (Previous  EP - Previous PSAR)

    Downtrend: PSAR = Previous PSAR - Previous AF (Previous  PSAR - Previous EP)

     

    Where

     

    EP is the highest high when we are in an uptrend move and the lowest low when we are in a downtrend move. 

     

    AF is a value between 0.02 and 0.2 that increases by 0.02 each time a new EP is reached. The most common setting is 0.02.

     

    The result of the calculation is a price value that is usually displayed as a dot on the chart, even though some traders prefer to see it as a line. The indicator is in an uptrend state until the price closes below the last Parabolic SAR value, and vice versa for the downtrend state. 

     

    Parabolic SAR in Fondex cTrader

     

    Parabolic SAR displays a series of dots on the symbol chart. We can see an example of a plotted Parabolic SAR indicator from Fondex cTrader below.

     

    Parabolic SAR in Fondex cTrader

     

    To add a Parabolic SAR indicator in Fondex cTrader, right-click on the chart and navigate to Indicators > Trend > Parabolic SAR. After clicking on Parabolic SAR, the below form will appear. 

     

    To add a Parabolic SAR indicator

     

    In this form you select the Min AF, the Max AF, the Shift, customize your line’s color thickness and type and press OK. The Parabolic SAR indicator will be added on your chart.

     

    Parabolic SAR Strategies

     

    Stop and Reverse Strategy

     

    As mentioned above, Welles designed Parabolic SAR as an indicator that would detect price reversals and new forming trends. Therefore, a simple strategy that uses the Parabolic SAR detects entry points to enter the market on Parabolic SAR reversals. Simply put, the strategy says that you should enter a buy position as soon as Parabolic SAR reverses to an uptrend and enter a sell position when the Parabolic SAR reverses to a downtrend. Below is an example of such entry points using this simple rule.

     

    Stop and Reverse Strategy

     

    On the chart above, we can see arrows where hypothetical entry points should be based on the simple stop and reverse strategy, green for buy orders and red for sell orders. We can see that this strategy can work well in trending markets, however, when the market is ranging, it can generate a lot of false signals. The chart below shows a case of a ranging market with a lot of false signals.

     

    Ranging market with a lot of false signals

     

    Parabolic SAR and SMA strategy

     

    A more advanced way to trade the Parabolic SAR indicator is to combine it with another longer term trend indicator, a simple moving average for example. The basic principle of such a combined strategy is to trade only towards the direction of the long term trend. If, for example, a 200 period SMA is in a bullish direction, perhaps it could be wise to trade the Parabolic SAR buy signals. If the SMA is in a bearish direction, maybe it’s worth considering trading the sell signals instead. When combining the Parabolic SAR with another trend indicator like moving averages, you are able to filter out trades that go against the current longer term trend and it may stand as a better chance of improving your trades. In the chart below, we can see a setup of Parabolic SAR and a 200 period SMA.

     

    Parabolic SAR and SMA strategy

     

    The moving average is indicating a strong bullish move for the EUR/USD symbol. In this case, the moving average would have filtered all our sell order attempts and permitted only buy orders. Based on the price movement on the chart, we can easily conclude that a lot of failed attempts to short the symbol would have been avoided.

     

    Parabolic SAR and ADX strategy

     

    Another method for filtering Parabolic SAR signals, proposed by Welles himself, is to use the ADX indicator, part of the Directional Movement System, as a confirmation indicator. A simple strategy combining these two indicators is to consider Parabolic SAR buy signals only when the the ADX value is above a certain level e.g. 20, and sell signals only when it is below that level. Below is an example of such signals.

     

    Parabolic SAR and ADX strategy

     

    Green vertical lines represent the buy signals where the Parabolic SAR changes direction and red vertical lines - the respective sell signals.

     

    Parabolic SAR as a Trailing Stop Loss

     

    Another popular use of the Parabolic SAR indicator is as an exit indicator, instead of an entry one. Many traders use other technical analysis techniques to spot entry points and prefer to use the Parabolic SAR prices as trailing stop loss levels. 

     

    Limitations of the Parabolic SAR

     

    Parabolic SAR, as any other technical indicator, always needs to be used in context. An out of context interpretation of Parabolic SAR patterns can generate a lot of false signals that could lead to substantial losses. Therefore, when using the Parabolic SAR, always consider the market fundamentals that currently move the market, and combine the signals with other confirmation signals, like trend indicators, support/resistance levels and the relevant price action taking place on the chart.

     


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#Educational#indicator#Indicator#SAR#Parabolic