The Parabolic SAR is a technical indicator used for technical analysis. It was developed by J. Welles Wilder that wanted to determine the direction that asset will move. SAR is an acronym for stop and reverse. As from the name we can understand the is mainly used to identify potential reversals in a price trend of securities. This indicator can also be used to identify potential entries and exits in a trend and therefore enhance the trades of a trader.
The concept of using Parabolic SAR is that if a stock is not able to generate higher profits over time, you should liquidate it. It is a “time is the enemy” known concept. The use of this indicator is also advantageous in combination with other indicators. Thus, it should be used to determine the direction and change the direction of the trend. Then, for the determination of the trend strength, use another indicator.
The parabolic SAR is mainly working in trending markets. The founder, Wilder suggests that traders should firstly use the Parabolic SAR indicator to identify the direction of the price and then use other indicators to measure the strength of the trend.
To paint the picture for you, this indicator is usually displayed in the chart security. It is presented as a series of dots placed near the candlesticks. Generally, when the dots are placed above the price, it indicates a downward trend and shows a sell signal. On the other hand, when the dots are placed below the price it indicates an upward trend and shows a buy signal.
Note: The signals are used to put profit targets and set stop-loss orders.
When the dots are graphically presented on the charts are very easy to read and understand. What produces the signals is the dots when changing direction. For example, when the price is making big swings it can produce profits. However, the Parabolic SAR is working better when the market volatility and has a lot of movement. The indicator is not as accurate when the market is flat or in a ranging market.
The figure above shows the movements clearly. For instance, when the market is moving upwards meaning that the price of an asset is going up the dots are also going up. The pace accelerates with the trend.
The indicator uses the highest and lowest price in an asset as well as the acceleration to determine whether the SAR indicator dot will be displayed. The formula to calculate the Parabolic SAR is as follows:
Uptrend Parabolic SAR=Prior SAR+Prior AF (Prior EP-Prior SAR)
Downtrend Parabolic SAR=Prior SAR-Prior AF ( Prior SAR-Prior EP)
The dots that we talked about in the above paragraph is basically the result of these calculations. The dots are then plotted in the graph against the asset price movement, whether below or above. The dots then help traders understand the direction of the price.
Wilder suggests using other indicators after the Parabolic SAR is formed. Other indicators can be the average directional index momentum indicator to confirm the strength of the trend whether it is bullish or bearish. Other indicators similar to the above one that can be used are the moving averages and candlesticks patterns.
If you click on the moving averages you can find many examples as to how the signals can be confirmed.
It is a good indicator and very helpful to traders. As with most of the indicators, it is not perfect, and it has its own limitations.
The benefit of using the Parabolic SAR is that it helps to clarify the direction of price action. The stronger the strength of a bullish trend, the better results the Parabolic SAR. In addition, when the movement is against the trend the indicator gives an exit signal and protects the traders from losses when detecting a potential reversal. The indicator is more accurate in market trends that rally up significantly or declining strongly.
The limitations of are that it can produce false signals when the trend starts moving sideways. This lack of trend is causing the indicator to “panic” making it move back and forth around the price and this is where mixed signals are produced. Traders that choose to rely completely on the Parabolic SAR without any other indicators combined will result in huge losses.
Parabolic SAR is a good indicator for determining the direction of the price during the trend. Also, suitable for determining the reversal point in the trend, as well as for setting stop-loss orders. When the trend is stable, this indicator gives reliable signals. However, when prices start to move sideways, it gives false signals and prevents favorable trades, which are lost in such conditions. The conclusion is, Parabolic SAR is good for trading in the direction of the dominant trend. Due to these characteristics, it is desirable to use this indicator in combination with others, most often, moving averages.
Congratulations!!! You’ve made another great step towards understanding stock trading better. Try another term, like the average true range.