Why Is Parabolic SAR Indicator Useful In Trading?

In the financial market, traders need to define the current and future trends of securities. Thus, various tools are used to support investors with their trading strategies. The parabolic stop and reverse (SAR) indicator is used to determine an asset’s price direction and potential reversals in price.

SAR indicator was created by J.Welles Wilder Jr. and is commonly known as the “stop and reversal” system. It is a technical analysis tool that monitors the fluctuations of the market by analyzing the behavior of various assets such as commodities, shares, currencies, and indices. In this article, we will analyze the definition of SAR, its advantages and limitations, as well as various strategies that traders can apply.

What Is the Parabolic SAR Indicator?

In the financial market, investors use more and more sophisticated tools to establish an effective trading strategy. The parabolic stop and reverse indicator is an efficient system that not only monitors the trend direction of an asset but also indicates potential reversals in price. Thus, the SAR indicator, according to its creator, provides investors with the following:

• It monitors the current price of an asset.
• It may foresee upcoming reversals in the price trend.
• It may inform traders of potential entry and exit points due to a reversal.

The stop and reverse index as its name reveals uses a trailing stop-based method that comes after price fluctuations. The parabolic SAR strategy is depicted on a candlestick chart with dots. To create it, analysts place a dot below the price when it is an uptrend and over the price during a downtrend. The function of the SAR indicator is based on three components. Two of those are connected with the acceleration of the up and down movements respectively, and the third defines the maximum acceleration.

The Parabolic SAR vs. a Moving Average (MA)

In the financial world, various indicators are used to assist investors in reaching their trading goals. Parabolic SAR (PSAR) and Moving Average (MA) are both used as indicators that monitor the price trend of an asset yet they do it with different formulas.

MA is based on calculating the average price of data points in a specific past period and then placing it on a chart. PSAR, in contrast, spots the highest highs and the lowest lows and then uses an acceleration component. Each price chart is represented differently and provides distinct trade signals.

How Parabolic SAR indicator works

The SAR indicator is a technical analysis tool that follows the price movements. The function of that index is based on an acceleration factor that is dependent on the market that traders choose. The SAR is depicted on the chart with dots that are placed over or below the price bars. A considerable benefit of this index is that it gives space for the price to move higher or lower when the trend heads in one direction for a long period and then it accelerates to catch it up. However, the wider the time frame the smaller is the gap given and a price reversal becomes more possible to occur.

The dots on the chart are stop levels. When they are over the price bars the trend is going down and when they are below it the trend goes up. Most investors consider each movement as a different trading signal. Specifically, the dots under the candlesticks are conceived as bullish signs, meaning that traders should go long. The ones over the price bars are believed to be bearish signs, meaning that traders are advised to go short.

Essentially, the parabolic SAR is following the price of an asset. As the latter starts to move faster the indicator is accelerating until it catches up with the trend. However, it should be underlined that it may work effectively during a trend but it may provide false signs in a choppy market or on occasions that the price may move sideways. Last but not least, traders need to remember that the SAR is a “stop and reverse” system, and when a stopping point is reached the current trade closes and a new one starts.

How to Calculate the SAR Indicator

To calculate the Parabolic SAR traders need to monitor the movement of the price line. If the price started with a rising trend but when it closes it is below the SAR dots the following formula will be used:

Conversely, if there is an initial uptrend but the price closes above the SAR value then the formula that is used is the following:

Where:

• EP is the initial for the Extreme Price. It represents the highest high and the lowest low for an uptrend and downtrend respectively.
• AF is the initial for the Acceleration Factor. As the default value is set at 0,02 and it can reach up to 0,20. The AF is gradually increased by 0,02 every time a new EP is reached.

For traders to have a more precise calculation of PSAR they need to monitor the asset’s price for five or more periods while recording the highest highs and lowest lows (EP). Thus, if there is a downtrend the lowest low should be used as the first PSAR value in the formula, otherwise, the highest high will be the prior PSAR value.

How to use the parabolic SAR indicator

SRI and MACD are also technical indicators that are represented in different panels on the price chart, whereas the parabolic SAR is a chart overlay tool that is placed on the price chart. It is popular amongst traders as a lagging indicator since it follows the price direction of an asset. Moreover, the PSAR captures the trend moves and through the alternations of the trendline, informs investors of potential buy and sell signals.

The PSAR is represented on a chart with a series of dots that follow the price direction. When the dots are over the price line the traders may need to find a selling point and go short since this is a sign of bearish momentum and the market is on a downtrend. Conversely, if the dots are below the price bars the market is on an uptrend, this is a sign of a bullish momentum. As a result, trades tend to go long and try to find potential buy points.

It should be underlined that when the dots flip this is a sign of an upcoming price change. Thus, depending on where the dots were placed before the price could either rise or fall. The PSAR is very useful and trustworthy during a strong trend. However, during sideways moves or choppy conditions, it may produce false trading signals.

Last but not least, the PSAR can be used as a trading system. Each dot of the PSAR is a stop level. This is why the chart works as a “Stop and Reverse” mechanism and shows when each market period finishes or starts. Those trailing stops help investors to protect their capital and secure their assets.

Parabolic SAR strategies

The PSAR can be used in various ways depending on the trader’s investment plan. Thus, it is divided into three categories depending on the trading strategy each investor follows:

• Parabolic SAR breakout
• Double parabolic SAR strategy
• Parabolic SAR forex trading strategy

Parabolic SAR breakout

It is a strategy that defines the levels where potential breakouts may occur. Through the SAR chart, an investor can foresee an upcoming price reversal or trend break. Those signs are produced when the price flips to the other side of the PSAR line. Therefore, a simple breakout strategy monitors the movement of PSAR that enters the trending direction until a pullback occurs. Before the pullback takes place most investors may place a stop-loss so they will constrain their losses.

Below is demonstrated an example of the Alcoa stock chart. On the graph are marked the points where the entry and exit signals are located. The box indicates a strong uptrend of the stock’s price. Investors have already earned a good profit from the current trading. Moreover, there is a breakout at the exit point and the trade will be exited if it goes under the PSAR indicator.

Additionally, during a downtrend where the PSAR is over the price, if a breakout occurs and the latter comes over the indicator, a pullback to an uptrend is taking place. However, this type of strategy works more effectively for assets in a strong trend.

Double parabolic SAR strategy

Another type of parabolic SAR trading strategy is the Double PSAR which is based on the use of two different timeframes. One is the long-term which is defined first and follows the PSAR direction. The other shorter-term time frame is designed to follow the direction of the first. The following example demonstrates the AbbieVie chart share. It can be spotted that the share price is currently on an uptrend. The chart is measured on the timeframe of a day.

After the monthly chart, traders can use the short-term charts such as the hourly or the 30-minutes. The second chart must be on the scale of a smaller time frame than the first of the longer term. The chart demonstrates the 30 minutes time frame.

Parabolic SAR forex trading strategy

The PSAR is an indicator that can also be applied in Forex trading. It has already been underlined that the indicator is more effective and valid during a strong trend. In the chart below the blue boxes show periods where the price movements were choppy. As a result, investors are facing multiple losses or small profits from their trading activities. The highest profit is a result of a big trend and comes from the difference between the entry and exit points of the PSAR chart.

Below follows an example of a double PSAR forex strategy that involves two time-frames necessary to define the price trend. It is a 15-minute chart of AUD/USD, where it can be seen that the trend is falling. This is connected with the second time frame that is depicted on the 1-minute chart that shows the declining trend of the price. Scalers make short entries when the price falls under the PSAR and exit trades when the latter goes over the indicator.

What Are The Advantages of Using Parabolic SAR?

The PSAR indicator offers various benefits to traders that choose to use it. Below follows a list of the advantages of PSAR :

• PSAR monitors and presents the price trend of an asset.
• During a strong trend, the PSAR offers significant and reliable information
• PSAR indicator helps traders to foresee upcoming trend reversals
• The indicator offers exit signals so traders will have smaller losses
• As a lagging indicator, it functions better in long trends.

What Are The Limitations of Using Parabolic SAR?

Of course, as with any technical indicator that supports traders with their investment choices, PSAR comes with its drawbacks. Some of the cons investors need to be informed of are the following:

• During a sideways market, the indicator is not as reliable and it may provide low analytical insight.
• If there is not a clear aspect of the market’s trend the indicator may constantly fluctuate around the price line.
• The continuous changes of the PSAR indicator around the trendline may give the investors misleading trading signals.
• This indicator offers reliable results only if the trend is strong and it should not be used when there are often alternations of the price trend.

Conclusion

The parabolic SAR is an efficient lagging indicator that monitors the current price trend and helps traders to foresee potential price reversals. Moreover, it is a technical tool that informs traders about the possible exit and entry levels. This way, they may prevent big losses or make better profits. It should be underlined that the indicator offers reliable and efficient results when the trend is very strong. Conversely, if the price moves sideways it may provide misleading information. Last but not least, traders should remember that the PSAR is represented as dots over and under the price line which are translated as bearish and bullish signs respectively.